On The Fiscal 'Cliff' (Not 'Slope') And The 3 'F's Of American Policy-Making
Some policymakers (and commentators) are attempting to make a molehill out of a mountain; seemingly less worried about the outcome of negotiations in the short-term, as they believe the cliff is not a cliff, but more of a slope, since economic damage will initially be limited while any equity market sell-off will only spur a resolution. We tend to side with Barclays and BofAML that the full set of expiring measures constitutes a cliff, not a slope. In brief, here is why - automatic withholdings and in Geithner's words "no authority to delay the process." The extent to which households can buffer this higher withholding is significantly weak as recent 'savings' rates have plunged - implying a need to draw on liquid assets to smooth any consumption shortfall. Citing Winston Churchill, BofAML sums up the siutation well - "You can always count on Americans to do the right thing - after they have tried everything else," and we remain stoic that stock market weakness and severe outside criticism will be important in forcing any agreement, as the politicians appear to face six signficant hurdles ahead.
It seems to us like we are following the same path as last year's debacle - what we like to call the Three 'F's of Fiscal Policy in America... Fear, Faith, and Oh F##K!!
Given the tight legislative calendar and the two parties’ gaping differences of opinion, we see a strong possibility that policymakers will “go over” the cliff, raising questions about how quickly a resolution can be reached before serious damage is done to economic activity and financial markets.
Some policymakers appear less worried about this outcome since, in their view, the cliff is not a cliff, but more of a slope, meaning economic damage will initially be limited while any equity market sell-off will only spur a resolution.
Our view is that the full set of expiring measures constitutes a cliff, not a slope. Although the full $650bn drag does not go into effect in January and will instead be phased in over the year, about $500bn of the total relates to revenues. Automatic withholding will begin to rise in January and Treasury Secretary Timothy Geithner has said his department has no authority to delay this process. Thus, additional withholding at a rate of about $40bn per month from higher marginal income tax rates, a higher payroll tax, and the alternative minimum tax (AMT), among other items, clearly point to a cliff in the BEA’s national income accounts (Figure 4).
The extent to which activity is buffered from higher withholding depends on households’ ability to smooth consumption. We believe households have limited room to maneuver. Personal saving in Q3 averaged $445bn (saar), about $100bn below the 2010-11 average and similar in size to expiring revenue provisions, suggesting households would need to draw on liquid assets. Moreover, saving is not evenly distributed throughout the population and tighter credit standards would likely limit many households’ access to credit.
Winston Churchill famously said “You can always count on Americans to do the right thing—after they have tried everything else.” This certainly seems to be the case with the fiscal cliff. Politicians have given themselves an almost impossible task. Consider the challenges:
- The election has returned the same cast of characters who created the cliff. Both parties need to do a 180-degree turn to compromise.
- The gap between the two parties in terms of both interpersonal relations and policy views is arguably the widest in modern history.
- They need to reach a deal by year end. And yet, in the first three weeks after the election there was just one brief meeting.
- The cliff involves 10 large and complex policy decisions: the Bush tax cuts and the sequester are only one-third of the cliff.
- Every recent major fiscal decision has gone to the last minute, with many false signals of a deal along the way.
- The debt ceiling hits shortly after the cliff. If it is not raised, the resulting austerity is more draconian than the whole fiscal cliff.
Our baseline forecast assumes a long, painful decision process followed by significant fiscal austerity. We expect a partial deal in late December where the two parties agree on some items and postpone others for several months. By the spring we expect all of the cliff items to be resolved and for there to be a process in place for negotiating entitlement and tax reform. We expect austerity equivalent to about 2% of GDP to kick in over the course of the first two quarters of the year (Table 2). We think stock market weakness and severe outside criticism will be important in forcing an agreement.
Some pundits dismiss the economic damage from the cliff. One view is that it will be resolved at the last second and the markets will quickly realize it was a nonevent. This ignores the fact that, unlike past brinkmanship moments, the cliff ends with significant fiscal tightening. Others argue that the fiscal cliff is really a fiscal slope: it will take time for austerity to impact the economy and people will largely ignore any tax increases or spending cuts because they will “know” they are temporary. This ignores the large and growing uncertainty shock from the cliff.
There has already been some belt tightening. The OECD estimates the structural deficit has already been shrinking by about 1.3 pp per year as federal stimulus fades and state and local governments cut. Assuming some slowing in cuts at the state and local level and our baseline for federal fiscal policy, the fiscal shock roughly doubles to about 2.5 pp in 2013. That’s a big hit for an economy that has had average growth of 2.2% since the recession ended back in 2009.
The cliff shock will likely rotate through the economy. Business leaders have already cut capital goods orders in anticipation of the cliff, but once the cliff is resolved we expect the release of some pent-up demand for capital. By contrast, households seem to be oblivious to the cliff. However, with the cliff now moving from business to front page news, we expect consumption to cool. Moreover, the tax increases and transfer cuts from the fiscal cliff will likely cut 1.9 pp off of income, stopping the growth in real disposable income in 2013.
In our base case, once the cliff is resolved, the economy will return to its moderate recovery. There has been substantial healing in the private sector since the 2008-09 crisis, and we are particularly encouraged by the housing healing. In other words, the 50 states are fine; the District of Columbia is the problem.