What's Next: The Good, Bad, And Ugly Of The 'Cliff'

Tyler Durden's picture

Time is running out. The cliff negotiations have devolved into two unpalatable options: (1) extend just the middle income tax cuts and extended unemployment benefits and allow about two-thirds of the cliff to happen, or (2) go over the cliff in the entirety. In BofAML's view, given the short time frame and legislative hurdles, the latter appears much more likely. Stock market vigilantes have replaced bond vigilantes as the potential good, bad, and ugly scenarios are devoured flashing red headline by flashing red headline. They, like us, believe that going over the cliff is not a benign “slope” as some suggest. Rather, it accelerates the already-building damage to the economy and markets. The latest evidence is the plunge in consumer confidence. Indeed, this could mark the beginning of the rotation in the uncertainty shock from businesses to consumers. Going over the cliff has many secondary, largely ignored, negative impacts, including tax changes that could damage the housing recovery, as well as negatively impact education and alternative energy, among many others.


Via BofAML: Life Over The Cliff

Over the coming weeks we expect politicians to agree to a series of partial patches, with some parts of the cliff delayed and others allowed to expire. The result would be a series of awkward decision points with attendant pressure on consumer, business and investor confidence.


Cliff or slope?

Optimists on the cliff outcome argue that it is a fiscal “slope,” not a cliff. We believe this view is correct in a limited sense, but wrong in a more fundamental sense:

  • The good news is that many of the cuts do not kick in on January 2. Some tax increases may not be immediately reflected in pay checks. Some spending programs will wind down slowly as they first use up existing cash balances. Moreover, even if the economy contracts for a month or two, a recession usually involves six months or more of decline and if cliff items are resolved retroactively, the economy could experience a mini-rebound.
  • The bad news is that in the real world expectations matter and just the possibility of going over the cliff has already damaged the economy. Capital spending cooled this year and recent consumer confidence readings have dropped sharply. Holiday shopping has already disappointed and downside risks to spending increase the longer the cliff casts its shadow. More on confidence below.
  • The ugly news is that going over the cliff reduces the urgency of getting a deal done. Once the deadline is violated, what induces the two sides to stop fighting and start compromising? Doesn’t going over the cliff suggest that each side believes the short term damage from going over the cliff is not as bad as the long term “damage” of a “bad” compromise? As we have seen in the past, often very strong outside pressure is likely needed to induce decisions in Washington. Historically, “bond market vigilantes” have been the disciplining force in ensuring responsible monetary and fiscal policy; today, “stock market vigilantes” are playing that role.

What’s next

While the most optimistic scenarios have been eliminated, a wide range of messy potential outcomes remain:

  • At this point, the failure to reach a deal means a “clean” grand bargain, where the two sides quickly compromise on most of the cliff items, is highly unlikely.
  • There could be a mini-deal, where they extend middle income tax cuts and extended unemployment benefits and allow the other two-thirds of the cliff to expire. The hurdles for such a deal are high: they require that Senate leaders agree, that all 100 Senators agree to expedited legislation, a majority of both the Senate and the House vote for the legislation and the President signs it. 
  • As such, the most likely outcome, in our humble opinion, is that all the cliff items expire—a fiscal austerity equivalent to about 4 ½% of GDP. Then in the coming weeks there are a series of partial patches with some parts of the cliff retroactively extended and others simply allowed to expire. The result would be a series of awkward decision points with attendant pressure on consumer, business and investor confidence.

While we expect to fall off the cliff, we believe the cliff is resolved before the end of Q1. The impact on the economy will depend on the following factors:

  • How long do we remain over the cliff? Each week without some resolution means more delayed spending, increased tax withholding and, most importantly, a deeper shock to confidence.
  • How many brinkmanship moments? The cliff is big and complicated. A clean grand bargain is unlikely, in our view. More likely are a series of smaller deals that patch up the cliff and prolong the uncertainty shock.
  • How big is the austerity and does it hit gradually or quickly? One of the most dangerous things about the cliff is that there is no phase in period — it all happens in the first year.
  • How serious is the damage to confidence for consumers, businesses and investors? So far the scars look relatively mild. 
  • How big a credit downgrade is there and is faith in Treasuries as the core of the global capital markets damaged? Up to now, the US has maintained its “safe haven” and reserve currency status. If that were damaged, the shock would be much bigger.

Our base case remains the same as it has been for over a year: GDP growth drops to 1% in Q1 and, once the cliff is resolved, growth gradually returns to trend. We expect the shock to gradually shift out of capital spending into the consumer. Households have been slow to recognize and react to the cliff and we expect tax increases to push the growth in real disposable income from 2% to zero next year. On a positive note, we do not expect a recession. We believe the private sector has recovered significantly from the 2008-09 crisis and growth would be above 3% absent the cliff. Hence, in our view, a recession is only likely either if more than a month is spent entirely over the cliff or if the brinkmanship battle extends into the second quarter.

Confidence cliff

In the fall, the cliff was a big topic of discussion in the business press, but was largely ignored in the popular press. Indeed, in six hours of presidential and vice presidential debate neither candidate was asked a single question about the cliff. That complacency has steadily eroded as the press and public have become increasingly aware of the risks (Chart 1).


Measures of consumer confidence tumbled in December (Chart 2). The weakness has been particularly notable among upper income households. This is likely because the press has focused on the possible rise in upper income taxes and has largely ignored the payroll tax and unemployment benefits.


Confidence has fallen despite signs of resilience in both the economy and the stock market. The expectations components have fallen much more than current conditions (Chart 3) — it is hard to see what could be the cause other than fear of the cliff.


Will consumer worries translate into spending cuts? The holiday shopping season has been weaker than expected; according to SpendingPulse, holiday sales grew by only 0.7% from October 28 through December 24, compared to a 2.0% gain over the same period last year. However, the drop in confidence came late in the season – what about post-holiday shopping? Consumer confidence readings have a mixed record in predicting spending. Often they simply reflect what we already know about the drivers of consumer spending — income and wealth. However, in times like these, confidence can offer important additional information. In our baseline forecast we expect consumer spending to slow significantly early next year, particularly for big-ticket items.

Under the radar

A number of additional sources of austerity will kick in without much notice once the cliff is reached. The caps to budget outlays, which were mandated with the debt ceiling compromise in summer 2011, will continue to restrain spending. In addition, accelerated depreciation for business expenses will be eliminated in 2013 (compared to 50% today), increasing the near-term tax burden for businesses. Moreover, infrastructure spending from Obama’s stimulus bill will continue to wind down.

There is also a “mini-cliff” that seems to have been largely ignored, but has the potential to cause real damage for the economy. Most notable is the AMT patch for 2012, which is needed to prevent a spike in taxes for as many as 20 million taxpayers. The “Doc Fix” for Medicare is another “band-aid” that Congress has put in place that would need to be extended. If no action is taken, payments to doctors will fall by a sharp 32% from 2012 to 2013, discouraging doctors from accepting Medicare patients.

We also cannot forget the long list of “tax extenders” that are set to expire at the end of 2012. At the top of this list is mortgage debt forgiveness relief, which was signed into law in 2007 to support the housing market. It allows taxpayers to exclude income from the discharge of debt on their principal residence. Currently if a homeowner does a short sale — owes $200,000 but sells the house for $150,000 — the homeowner does not have to pay taxes on the $50,000 of forgiven debt. After January 1, homeowners will have to pay taxes as regular income on their federal tax returns. For someone in the 25% tax bracket, this would mean paying $12,500 in additional taxes. This relief has helped to boost short sales—a smoother way to sell a distressed property, helping the recovery in home prices. If this is not extended, a greater share of delinquent borrowers will likely be resolved through foreclosure instead of short sale, which would depress average home prices.

Other tax extenders include extension of the deduction for state and local sales taxes, Production Tax Credit for wind energy, deduction for tuition expenses, and a farm bill to avoid what has become known as the “dairy cliff.” If Congress does not pass an extension of this bill, the country’s farm policy reverts back to laws dating from 1949 and the price of milk could rise significantly. Yet another example of how Washington, in our view, is playing with fire.

Reaching our limits

But perhaps the biggest challenge poised by any attempt at a post-cliff deal will be the looming debt limit. The Treasury recently announced that the statutory debt limit will be reached on December 31, at which time a set of “extraordinary measures” would be put in place, just as in 2011, to avoid default. However, these actions will likely postpone the day of reckoning over the debt ceiling until late February or early March, Furthermore, the more programs are allowed to expire, the later the true debt ceiling is hit. This buys time to negotiate, but those negotiations could be very contentious.

That fight could ensue quickly as both sides understand the importance of the ceiling. House Republicans maintain their demands for dollar-for-dollar spending cuts to support an increase in the limit. President Obama has countered repeatedly in the press that he does not intend to negotiate over the debt ceiling, arguing that the debt represents past obligations the nation is already bound to honor. Much as with many other parts of the fiscal cliff, the two sides remain far apart on this issue. Should debate drag on into the second quarter with protracted battles and partial fixes, our forecast for a second-half rebound in growth would be at risk. It would also significantly increase the chances of another debt downgrade and subsequent market selloff. Indeed, Table 1 shows that the size of the austerity implied by not raising the debt limit during 2013 (roughly $1 trillion) dwarfs not just any individual piece, but the entire potential impact of the fiscal cliff ($720 bn).


In sum, recent events have confirmed our expectation of a messy resolution of the fiscal cliff. Going over the cliff accelerates the shock to confidence that has already begun and the likely failure to avoid any of the cliff, suggests the post-cliff fight could be equally negative for confidence. We have not changed our forecast, for a growth recession, but no outright recession. On a positive note, so far the economy has held up somewhat better than expected. On a negative note, the political developments have been somewhat worse than expected. Resolving the cliff is just the beginning of the fiscal challenges for 2013, and it is not off to an auspicious start.

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maxmad's picture

I picked the wrong day to give up cough medicine!

NotApplicable's picture

I'm finding the number of people who start a discussion with me about "The Cliff" to be absolutely unreal. Especially given these are not people who have otherwise ever had a conversation with me anything relating to fiscal/economic matters.

They latch onto to a talking-point relevant to them, which defines their entire theory of why X needs Y.

All I can do is to constantly interrupt them with my rebuttal, "It's all fake and contrived!" until they finally shut up.

john39's picture

The cliff isn't really the issue. It is just an event that signals that the days of can kicking are ending. Maybe they find a way to kick the can again, but even then, it won't buy much time.

pods's picture

It is almost amazing to see how many fiscal experts have been created in the last month or two.  

I posted abou this before.  I have to take a Silkwood Shower after conversing with these experts.

The Stupid, it burns.


walküre's picture

Use the opportunity to educate them. At least they're awake and asking questions. Everyone naturally has an opinion. It's your perogative to help them see it the right way.

Clever Name's picture

"Contrived"? What are you, some kind of conspiracy nut? You make it sound like this was all drawn up some time ago by some kind of .gov 'committee'! Oh, wait...

Fish Gone Bad's picture

I went to see The Fixx on Saturday and was taken by their song, Saved by Zero.  Getting back to nothing gives people perspective on what is/was important.  I have been living a meager life for quite a while.  The world can collapse tomorrow and everything will sort itself out because it always does.

Bindar Dundat's picture

I think the best thing that the Congress and Senate can do is nothing.  Going over the cliff will certainly start the austerity program and match it with some tough tax increases. Politically it is good since both parties can blame the other for increased taxes and cutbacks in spending.  Sometimes a perfectly valid management option is to do nothing.  Let's hear it for doing nothing -- besides they are good at it.

Snakeeyes's picture

Commodity prices, for the most part, skyrockets in the past 6 months. Partly reflecting DC's malfunctioning. It will likely continue into 2013.


Gift Whores's picture

Obamacare has you covered so you don't have to! Yay!

Boilermaker's picture

I predict a declaration of victory and an instant 30 to 40 handle blast off on the SPX.  Double for the RUT.

Joe 401(k) will have a monster chubbie and ring in the new year.


Everyman's picture

I agree with the "declaration" of victory and the markets jumping up HOWEVER..... given the author's original take on the subject:

The cliff negotiations have devolved into two unpalatable options: (1) extend just the middle income tax cuts and extended unemployment benefits and allow about two-thirds of the cliff to happen, or (2) go over the cliff in the entirety.

OK then, with all the BS and theatrics we still go over 2/3 of the cliff even if these assholes reach some kind of agreement?  And that is FIXED??????  Seems to me that Moodies and the other ratings agencies will take this rather badly and the coming "downgrade" of US bonds will be the last straw.  The Sequestration reduction of GDP will not happen, but bonds will go up.  Additionally, nothing is fixed again, will 1/3 is but that is all just "buying votes" and that is it.  The debt still remains, and the spending still increases, and revenues only SLIGHTLY increase from the tax "cuts".  This is only smoke and mirrors to cover Obmamcare TAX  (fee) increases.

IF there is anyone out there that is still on fundamentals, this IS going over the cliff; 2/3 or full doesn't make any fucking bit of difference, unless you are high on heroin or hopium!


So the Congreess FAILED ALL OF THESE STUPID FUCKS.  They had 500+ days from the last "Debt Ceiling" increase to fix this, and reached an fucking agreement on automatic cuts and sequestration and tax increases, IF THEY FAILED TO ACT.  Now they just ignore the previous "arrangement".  Wonder how the ratings companies will take that little bit of "regression" as "Confidence that the USA can get their financial house" in order?

Curt W's picture

I believe much of the dive in consumer confidence is from watching the Idiots who are supposed to be in control, running around pointing fingers.

It reminds me of two 12 year olds blaming each other for the broken lamp.

Fish Gone Bad's picture

You are way too generous.  This is more like kids who have just started to learn to lie, make them 7 year olds, tops.

JustObserving's picture

Stock market vigilantes have replaced bond vigilantes

Both are mythical creatures like unicorns and dragons.  Mr Ben is the only vigilante now if you have been paying any attention at all.

NotApplicable's picture

Besides, if anybody decides to break ranks, they'll get Lehmaned.

You either front-run like a good boy, or they'll run you over next chance they get.

Go Tribe's picture

Better just buy the S&P now.

Al Huxley's picture

You know, regardless of all the media drama and hand wringing, the VIX is showing every sign of having spent its energy and topped out (in the near term), even with the market hardly down at all.  So actually, it probably is a good bet to buy the S&P right now, in advance of some 'miracle last minute solution' that turns out to be blatantly (as opposed to covertly) inflationary.  But with the readiness to bail quick, because the only alternative to the likely drop in the VIX and corresponding rise in stock prices will be a big crash a-la May 2010, or Autumn 2008. 

adr's picture

Or how about the government stops trying to control the price of everything.

So we have the "Dairy Cliff" and the cost of milk will skyrocket? Who is going long dairy futures on that news?

End Washington, End the Fed, End the Market.

Was there really something wrong with producers and consumers determining the price of goods?

NotApplicable's picture

Wrong? According to the parasites that run things, there is.

buzzsaw99's picture

I suggest a new strategy, R2: let the Wookie win.

adr's picture

I volunteer to rip the arms out of the sockets of everyone who works on the top floor of a bank and every politician in DC.

ebworthen's picture

They're getting everyone whipped up into a froth, until even the most uninformed plebian will be heard to say "we have to do something about the fiscal cliff".

Then, CONgress will pass higher taxes on everyone, cut already taxed entitlements, move retirement age to 70, and take away more individual liberties.


Our society is NUTS, NUTS, NUTS!!!

Rip van Wrinkle's picture

That's what happens when 350 million people are more interested in the Redskins/Cowboys game than politics or economics.


Whole generations completely and utterly brainwashed.

walküre's picture

We have not changed our forecast, for a growth recession, but no outright recession. On a positive note, so far the economy has held up somewhat better than expected. On a negative note, the political developments have been somewhat worse than expected.

Dreamers in Lalaland. The economy "held up" because Ben brought his punch bowl to the party. The novelty has worn off and the punch has been diluted. Take the punch bowl away or give it more time until dilution turns it into water and let's see where we're really at.

ZFiNX's picture

I think our larger concern is not when the cuts will kick in, but when they will be priced in, an event which will be more immediate and severe. Not to mention more relevant to the average ZHer positioned in equities. Gold ought to see a huge correction, too, I imagine, talk about some dampened inflation expectations. I can't believe all the monetization that has already occurred has failed to push the DOW through the 07-08 highs, that forebodes problems on a scale unseen since the decline of the roman empire.  Please, China, oh please come through. China. Please.

Headbanger's picture






tuttisaluti's picture

Where are the rating agency's in this case. It's so quiet there.

ebworthen's picture

Rating agencies?

You mean the ones that called dead horses as coming around the home stretch in the money?

LukeWorm's picture

Who legislated this stuff that would enter into force ?  

s2man's picture

Weasels who couldn't/wouldn't make a decision years ago.  They kicked the can down the road so shit would happen on someone else's watch.

We should have had a deflationary depression in 2000, and we'd be in a real recovery by now.  But bankers can't handle price deflation on assets.  And since bankers run the world, now, they get to "target" mild inflation for the rest of our lives.  Their plan is doomed to fail in a much worse manner than a simple economic depression.

Debt-Is-Not-Money's picture

"And since bankers run the world, now, they get to "target" mild inflation for the rest of our lives."

The've been targeting "mild inflation" for the last 99 years! what could be purchased in 1913 for two or three cents now costs a dollar.

walküre's picture

Good synopsis of all that has gone wrong and by design. This should be taught in schools.

SubjectivObject's picture

This is a comprehensive summary of the bankster psyops.


awakening's picture

Very well written article, many thanks for sharing.

Dr. Engali's picture

Drive this pig straight off the cliff, use some people from Washington/Wallstreet as air bags, and the sun will still come up tomorrow.

PUD's picture


Curt W's picture

Where have I been surfing, when the ad on top is for Big Girl Bras.

ebworthen's picture

Did you search for "suckling government teat" or "milking the middle class"?

Curt W's picture

lol no the only place other than here this morning was cnn money, to see the ticker.  My browser is supposed to clear everytime I log off.

SKY85hawk's picture

My wife doesn't enjoy the girly dating sites and wants to know what I've been up to!

Link to a retail site that you like.  That confuses 'G' for awhile.

I use Radio Control airplanes. 



Fish Gone Bad's picture

Mixing it up will make things more enjoyable for everyone concened.  Get a FREE copy of the Sanboxie program (a cheap version of VM Ware), it keeps all your surfing in a location that can be dumped easily and reset.   Now go and clear your history/cache.  Now start up Sandboxie and surf around to hardcore German dungeon porn sites and Japanese porn sites.  That ought to make your ads a bit more interesting.  To undo your changes, just "dump" Sandboxie by deleting its contents.

I once had a job I thought I was going to be fired from anyday.  So I ran everything through Sandboxie.  Every night when I went home, that computer was clean.

wee-weed up's picture

Table 1: Top 10 fiscal to-do list

9. Obamacare taxes... ONLY $20B

You gotta be shittin' me!

Marley's picture

Man, my bullsh*t meter is pegged ultra high.  The war on the poor continues.

sgorem's picture

The ugly, the uglier, and the ugliest is where we are at. I for one hope the WHOLE fucking thing collapses and the sloths of the US in particular, and the world in general pay dearly for the "CHOICES" they have made. I'm ready, been ready for a long time. Let her burn Bitchez!

khakuda's picture

All this BS could be summed up easily as follows:  If we stop running up debt and spending money we don't have, then the economy wouldn't look so good, so we will ultimately chose to continue near term fake prosperity instead as long as we are allowed to.  When the markets say no, we will let the government take over the markets to keep the game going.  Be damned the long term consequences.

It's how a child would manage the economy and they should all be ashamed.  Leadership is about doing the right thing, in spite of the short term cost.  Bernanke, Obama and Congress are not leaders.

TacticalTrading's picture

Cliff has pulled a lot of activity into Q4, which comes at the extraordinary expence of a much weaker than expected Q1

Payroll tax Holiday ends: The End!

Oh yea, The policies of 1949, aka, the Dairy Cliff

And thus, we have the true meaning of hope and change...

I hope 'they' like what they voted for