Goldman On The Fiscal Cliff: Worse Before It Gets Better
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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