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