Goldman On The Fiscal Cliff: Worse Before It Gets Better

Tyler Durden's picture

As we have explained recently, the US fiscal cliff is a far more important issue 'fundamentally' than the Fed's economic impotence. While most market participants believe some kind of compromise will be reached - in the lame-duck session but not before the election - the possibility of a 3.5% drag on GDP growth is dramatic to say the least in our new normal stagnation. As Goldman notes, the window to address the fiscal cliff ahead of the election has all but closed, the 40% chance of a short-term extension of most current policies is only marginally better than the probability they assign to 'falling off the cliff' at 35%. The base case assumptions and good, bad, and ugly charts of what is possible are concerning especially when a recent survey of asset managers assigned only a 17% chance of congress failing to compromise before year-end. Critically, and not helped by Bernanke's helping hand (in direct opposition to his hopes), resolution of the fiscal cliff will look harder, not easier, to address as we approach the end of the year - and its likely only the market can dictate that direction - as the "consequence is terrible, but bad enough to force a deal."

The Consequences Of The Fiscal Cliff...

The base case: a short-term extension



In May, we outlined four potential scenarios for how the fiscal cliff could end. In increasing order of probability, they are as follows.


A grand bargain (5%). Depending on the election outcome, it is possible that lawmakers could aim for a grand bargain before year’s end that trades slower spending growth favored by many Republicans with increased tax revenues favored by many Democrats. However, the likelihood of actually agreeing to such a plan before the end of the year remains low, particularly because lawmakers would have only a few weeks to sort out the details. Earlier this year we pegged the chances of such an outcome at 5%, and it does not look any more likely now than it did then.


A one-year or longer extension of most current policies (20%). Both parties are aiming for one-year extension of their priorities. This summer, Senate Democrats passed a one-year extension of middle-income tax cuts. House Republicans passed a one-year extension of all of the expiring income tax cuts as well as a one-year delay in most of the sequester, replacing the foregone savings with domestic spending cuts spread over several years. While both parties might like to do so, enacting a one-year extension prior to year‘s end seems likely to occur only if the two parties are able to compromise on contentious issues like the upper-income tax cuts, the election result prompts a change in policy positions from where they currently stand, or the (more likely in our view) short-term extension discussed below is deemed unworkable or impractical.


Falling off the cliff, at least temporarily (35%). Earlier this year, we estimated the probability that lawmakers would fail to address the fiscal cliff by the end of the year at 35%. Developments since then imply an increased risk that the year-end issues might not be addressed: senior Senate Democratic Senator Patty Murray (D-WA) indicated in a high-profile speech that Democrats would accept “continuing the debate in 2013” if no agreement acceptable to congressional Democrats could be found in 2012; House Speaker Boehner (R-OH) once again stated that Republicans would insist that the next increase in the debt limit be accompanied by commensurate deficit reduction, and campaign rhetoric has predictably highlighted policy differences. While a 35% probability that the year-end deadline will not be met might have seemed high a few months ago, developments have caught up and at the moment the risk appears at least as high as our prior estimate.


A short-term extension of most current policies (40%). While a bottom-up perspective--major differences between parties on key issues, lack of a clear strategy for extension, potential political complications caused by the election, and limited time after the election to reach agreement—implies a risk of failure even higher than the one in the one in three chance we estimated in May, from a top-down point of view, it is simply hard to believe that Congress and the President would let fiscal policy differences worth around $100 billion—the defense portion of the sequester and the upper income tax cuts in 2013—result in such a large amount of fiscal restraint that it could push the US into recession if it were allowed to take hold more than for a short period. So while our confidence in this outcome is a bit shakier than it was earlier in the year, we still believe this is the most likely outcome.

The election result will play a role in the outcome of the fiscal cliff...

Some recent Presidential elections have implied significantly different fiscal policy outcomes based on the electoral results. In thinking through the effect of the election on the resolution of the fiscal cliff, three principles may help to clarify potential outcomes.


A political mandate for either party increases the likelihood of an agreement before year’s end: A significant victory by either party, in an absolute sense and also relative to expectations, would strengthen their position in negotiating a year-end agreement. This was the case in 2010, when following their winning the House majority, Republicans won extension of the 2001/2003 tax cuts, despite the fact that the White House and Congress were at the time still controlled by Democrats. If President Obama wins reelection by a comfortable margin and Democrats hold onto a slim Senate majority, or if Gov. Romney wins the White House, we would expect the winner to gain “political capital” that should, all else equal, help an agreement come together. Conversely, a mixed outcome—for instance, Republicans take the Senate but not the White House—would provide less clarity.


A change in control, all things equal, creates an incentive to delay; incentive to delay: If control of the White House, House, or Senate changes hands, the party coming into power is less likely to compromise with the thought it is likely to reach a better outcome once it has taken power.


The need for political compromise increases uncertainty and the risk of failure. Split control of government—for instance, if the status quo is maintained with a Democratic White House and Senate and a Republican House—means that a political compromise would be necessary to reach agreement either before year’s end or early in the new year. A bipartisan compromise is generally difficult to achieve, and is even more difficult under not only a dividend government but a divided Congress (the current situation).


Taking these factors into account, we have constructed the matrix below:


Don't Forget The Debt Limit...


As shown in the chart above, we expect the Treasury to exhaust its financing capacity under the debt limit by sometime in February, necessitating a legislative increase in the limit by that point (if Congress failed to address the debt ceiling by that point).


Ideally, as part of a year-end agreement Congress could also push the debt limit deadline out a few months, so that lawmakers could combine the deficit reduction policies they may enact with the next debt limit increase with the longer-term or permanent resolution of the sequesterrelated spending cuts and 2001/2003 spending cuts. That said, it is quite possible that this could be too much to accomplish in the lame-duck session of Congress ahead of the year‘s end and that Congress enacts a short-term extension of the debt limit in early 2013.


The fiscal cliff will look worse before it looks better...

While we are hopeful that lawmakers will manage to reach an agreement before year‘s end, we expect that the road to such an agreement will be a bumpy one.


Ahead of the election, lawmakers seem unlikely to reach any sort of compromise on major tax or spending policies, particularly now that the window for a legislative agreement is essentially closed. Once the election results are known, lawmakers will work toward compromise, but members of both parties have an incentive to make the threat of “falling off the cliff” appear as credible as possible, so a resolution in November, or even early December, seems unlikely. Indeed, under a status quo election outcome, for example, a decision on even a short-term extension of expiring policies seems unlikely until late December, since political compromise would presumably come only after all other options have been exhausted.


It appears to us that market participants are not pricing in as much of a risk of a legislative failure. As noted above, we think there is at least a one in three likelihood that lawmakers fail to agree by December 31. By contrast, our colleagues in Goldman Sachs Asset Management found in a recent survey of fund managers that the average probability assigned to missing the year-end deadline is only 17%.

As noted above, if a deal is reached by the end of the year it may not provide much certainty in 2013. After all, the debt limit may still need to be raised, and the since the most likely scenario seems to be a short-term extension of fiscal cliff-related policies, the risks from fiscal policy seem likely to continue into 2013, regardless of how the fiscal cliff is dealt with at year’s end.

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Vincent Vega's picture

I expect Congress will take a play straight out of The Bernank's playbook: Debt Ceilingternity. <bitchez>

johnQpublic's picture

that actually sounds plausible

roadsnbridges's picture

With Boner in there, you betcha.

Kitler's picture
Goldman On The Fiscal Cliff: Worse Before It Gets Better


Better for who?

Probablity of additional free trillions to the banksters from the Fed: 100%

CrashisOptimistic's picture

There were errors in that analysis, and possibly politically driven.

Boehner did not say no debt ceiling increase without an equivalent reduction in deficit.  He said no debt ceiling increase without an equivalent CUT IN SPENDING.  He did not open any doors for tax hikes.  He said equivalent cut in spending, which is exactly what he said in August 2011 and ostensibly got with 1 Trillion cut from the baseline in present law and the 1.2 Trillion Sequester spending cut coming in January.

Watch carefully any phrasing like this.  He said spending cuts.  Not deficit cuts.


The overall thing to be aware of is this: There is no proposed or imagined compromise of any kind that is stimulative.  All the scenarios are GDP restrictive or At The Very Best, GDP unafffected by leaving current policy in place (and doing another 1.25T deficit in 2013).  Any compromise is at least somewhat restrictive of GDP.

johnQpublic's picture

wile e coyote approaches fiscal cliff..........

goes off cliff

smacks in to the ground

gets up

does it again

buzzsaw99's picture

what a bunch of assholes

lolmao500's picture

War is bullish... so... bullish :

Der Spiegel: Syria tested chemical weapons with aid from Iranians at end of August (Haaretz)

john39's picture

what a surprise, haaretz...

ShrNfr's picture

The Der Spiegel article is that they tested delivery systems, not the weapons themselves. A distinction without a difference perhaps.

101 years and counting's picture

bernanke killed any chance of the cliff being resolved PRIOR to arriving at it.  not a chance the republicans will negotiate after ben pulled out his printer.  once the economy freefalls a few months, an agreement will be made, which will also backdate the extension.  

Dr. Engali's picture

What if there is a false flag and elections are "temporarily suspended"? What happens with that scenario?

ShrNfr's picture

The prospects are revolting to contemplate.

ShrNfr's picture

The prospects are revolting to contemplate.

Oldballplayer's picture

For that to happen you would need the support of the Army and Air Force.  That chances of that are too small to calculate.

Bicycle Repairman's picture

The compromise will be no spending cuts, higher taxes and the Bernank opens up the $ spigot.  The end.

CrashisOptimistic's picture

There are no projections of the Tea Party led GOP losing the House.  What are the odds of them signing onto a higher taxes, no spending cuts scenario?

Bicycle Repairman's picture

They'll sign on for no defense/security cuts.  And you'll see their real colors.

Venerability's picture

Dear Goldman,

None of this is actually helpful, unless you tell us on exactly what trading day the "Thelma and Louise Moment" is slated to occur and on what trading day the "Miraculous Rescue From the Brink" is slated to follow it.

In the slightly shorter term, it would be interesting to find out what reactions the market will be permitted to have immediately after the election, depending on whether the Obama-ites re-take the House or not and thereby get clear sailing for whatever the heck they want to do.

TimmyB's picture

Shorter Goldman:

"Keynes rules bitches!"

The "Fiscal Cliff" shows that everyone believes in Keynes. As Keynes said, if we want to cut GDP in a recession, all we need to do is raise taxes and cut government spending, same as Greece, England, Ireland, ect. The proof? Look at what has happened to all of the countries listed.

And this is all the "Fiscal Cliff" is, a series of federal tax increases and budget cuts that will take effect shortly if nothing is done to change our laws. So obviously, if you are a "Fiscal Cliff" Chicken Little, then you believe in Keynesian economics.

FreedomGuy's picture

Tap your heels together and say three times, "There's no place like the Fed!" and all will be well.

Northeaster's picture

They are all lying jackasses in CONgress.

The public debt will NEVER be paid down. The private debt will NEVER be paid down.

Even though the military should have cuts, Ryan slipped in his Bill to make sure the military goes untouched. So much for fiscal responsibility:

Then again, it's status quo and the rest of us will pay for it, until we can't. The slow-motion economic train wreck continues.

q99x2's picture

I thought that they got rid of the budget and replaced it with QEinfinity. 

Bernank vaporized that fiscal cliff thing. What people are still seeing is a mirage. Pay no attention. BTFD.

CNBC is funny when they talk about buying into the market while there is no logical reason to do so except for the banksters printing.

rqb1's picture

anyone who belives that goldman is going to tell the real story is fooling themselves. 

NoWayJose's picture

We won't see any more sequester language put into future spending laws, that's for certain.

Calidreaming's picture

I heard someone say that the debt limit will actually be hit by OCt 1

Calidreaming's picture

I heard someone say that the debt limit will actually be hit by OCt 1

Snakeeyes's picture

Want to see why the fiscal cliff can't be avoided? i was on CNBC's Closing Bell with Maria Bartiromo discussing QE3. mbs purchases and unintended consequences today. Bruce (Karl) Marks from NACA filibustered the interview ranking on bank servicers (and what did that have to do wiith Fed policy???)

The point is that there are politicians and parasites in the US that NEVER want any responsibility, fiscal or otherwise.

The interview is near the bottom.

MoneyShaman's picture

Fiscal cliff is bunch of hyberbole to me. Big deal cutting spending the military industrial complex, and tax increases. Government bureaucracy is not the real economy. Instead of lenders lending to the government at ultra cheap rates, it should have use those resources for investments  today, or in the future.


Of course on the surface people who get fired from those bureaucratic jobs will contribute to the unemployment number, but hey they are really just parasites anyways. The real fiscal cliff is a currency crisis. Might as well balance the budget right now for long term stability. Of course, this hyberbole is just Keynesian speak. Republicans like it, because they don't want to cut military spending, and honestly think military spending is geniune economy. It's not.


Government spending is a burden just like taxation is. The idea we must keep borrowing on ultra cheap rates to sustain unproductive jobs is nonsense. Bush tax cuts are temporary anyways as well. They are not permanent. They were installed to as a economic stimulus after 9/11, and internet stock market bubble popped.

Want to generate wealth, fiscal cliff is not so worrisome