Brace for a QE3 comedown

I suspect that when the Bernanke celebrations die down the fiscal cliff will dominate the headlines.

At the weekend the veteran US economist Al Wojnilower sent me a note showing how the fiscal cliff will prevent Bernanke's QE3 from rekindling US corporate investment and/or consumer spending to lower unemployment.

Wojnilower believes that American companies have a deep-seated fear the US could end up with an austerity regime similar to southern Europe.

At the moment Wall Street shares are basking in record profits, high profit margins, low interest rates and bulging corporate cash positions. Every business model that management schools might dream up would conclude those circumstances would trigger stronger business commitments to hire and spend on capital works.

But instead, capital investment is slowing.

Wojnlower says that some of the reluctance of companies to invest may be explained by the turmoil in foreign markets and residual concerns from GFC.

But the principal explanation is the "intensifying apprehensiveness, indeed fear”, as the calendar brings the economy closer to the fiscal cliff and the long-lasting depressed conditions that lie beyond that cliff.

Business Spectator's US correspondent, Alexander Liddington-Cox, alerted readers to fiscal cliff dangers (QE3 launched into a fiscal cliff abyss, September 14).

Wojnilower tells me that if political agreement is achieved relatively amiably and quickly, perhaps US GDP can continue to slog ahead at a 2 per cent  annual growth rate. But if there is no early compromise that substantially mitigates the impending surge in tax rates and across-the-board cuts in government expenditures, "the economy will embark on a new recession, with no parachute to cushion the prolonged fall”. If so, many businesses currently undertaking capital expenditure increases will be accused, in retrospect, of having been reckless.

There is grave risk that the Congress – and perhaps the country – remain too ideologically divided to agree on timely steps to avoid the plunge. Some observers believe that the gridlock will be more easily resolved after the election. But even if they are right, the public faces months of trepidation before a trustworthy compromise can be reached and enacted, and its content evaluated.

In the meantime the lapsing, at year end, of the payroll tax reduction and of extended unemployment insurance benefits, which are unlikely to be reversed in any ultimate 'deal', will open a gaping hole in household budgets. 

That will happen even if the major tax increases that would result from the end of the so-called 'Bush tax cuts' are somehow delayed or postponed. The 'sequestration' cutbacks in federal spending required by recent law, even if implementation is half-hearted, will deepen the concerns of the many companies and workers whose incomes derive from government contracts.

Wojnilower says that should a bipartisan agreement be reached along the lines of the aborted so called  Simpson-Bowles plan, business and financial markets would heave a huge sigh of relief. Stock prices and long-term interest rates would probably rise. 

The plan reportedly consisted of long-lasting expenditure cuts, coupled with enlarged aggregate tax revenues generated by unspecified reforms. But with household saving already near rock-bottom levels, further income cuts would make it virtually impossible for consumers to step up spending and borrowing. An enormous – and unlikely – surge in business capital spending would therefore be necessary to outweigh the recessionary impact of such a fiscal agreement. 

The US would be inflicting on itself an austerity regimen resembling that which the German-led bloc in Europe is imposing on its southern neighbours. "The end result – economically, financially, and socially – would be unhappy,” Wojnilower says.