Over the fiscal cliff

‘Fiscal cliff’ is one of the world’s newest neologisms, an expression that everyone’s heard of but no one quite understands. We’re writing about it here to enlighten rather than add to the perfect storm of clichés. It might not die off like 'green shoots' (2009), 'geopolitical environment' (2003) and, hopefully, 'RuddBull' (2012).

If we do it well enough, in 10 minutes time you won’t need to read or watch anything more about the fiscal cliff ever again. And you’ll know what to do if and when the sh*t hits the fan.

What is the fiscal cliff?

To understand the fiscal cliff, let’s first traverse the political topography that preceded it.

Prior to 1917, the US government directly approved each request by Treasury to issue more debt. That became a bit tricky during World War 1 when the US was financing a war. Too cumbersome.

So instead of requiring congress to approve each debt issue, a debt ceiling was introduced. Treasury could now borrow up to a level pre-determined by congress. Approval was required only to raise the ceiling, not the issue of additional debt below it.

Until recently, there was bipartisan agreement to constantly increase the debt ceiling, as Chart 1 shows. In the last 50-odd years, it was increased on 72 occasions; 18 under Reagan, eight under Clinton, Bush Jnr. seven, and three times under Obama. The debt ceiling crisis of 2012 broke this long-standing arrangement.

Over the past 40 years, US debt as a percentage of gross domestic product (GDP) averaged about 37%. In 2008 it was 40% but increased to about 70% by 2011, largely due to the Bush tax cuts, the bank bailouts and the wars in Afghanistan and Iraq.

The debt was too high and the Republicans especially believed something must be done about it.

What did they do?

A classic bit of horse trading. The Democrats wanted to increase taxes on the rich by letting the Bush tax cut legislation lapse and make minor cuts to spending. The Republicans wanted to avoid any increase in taxes but slash government spending, except on the military. The negotiated settlement was The Budget Control Act of 2011.

This immediately increased the debt ceiling and specified government spending cuts of about $1.5 trillion over 10 years. A super committee was established to produce legislation committing congress to these reductions.

But the bill contained a nasty little poison pill: if congress failed to approve at least $1.2tn in spending cuts, there would be across-the-board government cuts in mandatory and discretionary spending, and tax increases, starting from 1 Jan 13.

That poison pill is the fiscal cliff. In failing to reach agreement, the super committee marched everyone towards the cliff. Now we’re standing on the edge of it.

Where will the fiscal cliff axe fall?

Love your mixed metaphors. The cliff contains measures to raise taxes and cut spending. Tax increases will occur from letting the Bush-era tax cuts lapse (the Congressional Budget Office (CBO) estimates they would cost over $3tn over the next 10 years if they remained), expiration of the 2% payroll tax and the reversion of tax thresholds. Taxes would also increase on high income earners as a result of Obama’s new healthcare legislation.

The Republicans aren’t so keen on the tax increases bit. But the legislation has already been passed. If they want to avoid them, a new deal must be struck before the end of the year.

Same goes for the Democrats. They don’t want across-the-board spending cuts (known as ‘sequestration’) but if they don’t negotiate a deal in the next few weeks, that’s what will happen.

The net year-on-year effect of the fiscal cliff is that tax revenues are projected to rise by about 20% and government spending reduce by 0.25%.

That may not sound like much but the US government spends a lot of money. If you’re a doctor, a defence contractor, a public sector employee, or you’re poor, this legislation puts a target on your back.

The impact is not equally spread, though. Whilst rich and poor alike will pay more in taxes, the rich will pay far, far more. The Tax Policy Centre estimates that those on about $50,000 a year will pay about $2,000 more in taxes next year. Those on $500,000 will pay an extra $50,000 and the top 0.1% will get slugged an extra $634,000. If Ayn Rand is turning in her grave, Karl Marx is having a house party on top of it.

What would be the economic effects?

The CBO has modeled two scenarios. Chart 2 shows how they play out. Under the baseline projection, the policies mandated by the fiscal cliff lead to a dramatic fall in government debt. In the alternative fiscal scenario, where the tax cuts remain in place and government spending continues unabated, the debt grows—a lot.

At least in the short term, that’s not the real issue. It’s the impact of policies designed to reduce the deficit on economic growth.

In getting the debt down to 58% of GDP by 2022 (the baseline scenario), the CBO estimates that the unemployment rate will increase from 8% to 9.1%. GDP growth, projected to be 1.7% under the alternative scenario, would be minus 0.5% under the baseline case.

That’s a sure-fire double-dip, super-quick recession and another million people out of work.

They won’t let that happen will they?

As Winston Churchill said, ‘You can always count on Americans to do the right thing—after they’ve tried everything else.’ Right now they’re trying everything else.

Obama has said ‘no deal’ to any proposal that doesn’t involve revoking the Bush tax cuts. That forces the Republicans to make the argument for tax cuts for the rich and pain for everyone else. Not easy.

Obama has a few more slight but notable advantages. First, he won. More people voted for him knowing that he wanted the Bush tax cuts to lapse. He has more legitimacy now. Second, the balance of power in the Senate has shifted slightly towards the Democrats.

Third, when negotiating with the Republicans over the debt ceiling last year, Obama faced an election in less than a year. Default wasn’t an option then, too much economic and electoral pain. He had to negotiate. With four years up his sleeve and no election to worry about now, dealing with the political consequences of a recession are much reduced.

Finally, plenty of Democrats like the idea of higher taxes on the rich and lower defence spending. All they have to do to get that is…nothing. And Republicans know it. You wouldn’t say the Republicans are in a weak position but it’s weaker than it was last time around.

So Obama has it sewn up?

Not quite. If agreement isn’t reached by year-end, the economy won’t collapse immediately. Program cuts will grow as the months pass, a fiscal slope rather than a cliff.

There’s more time than everyone thinks to get a deal done and avoid another recession, although markets are already nervous. Eventually, sense should prevail (yes, we’re all laughing on the inside, too). The debt needs to be reduced but it shouldn’t require a recession to do it.

If a deal isn’t reached, February or March next year will be key. By then, congress will need to approve another increase in the debt ceiling and the pantomime resumes. But the political environment is different; you’d expect US politicians to hammer out a deal that avoids the prospect of a recession eventually, after they’ve tried everything else.

How does this affect my portfolio?

During our recent roadshow, research director Nathan Bell frequently bemoaned the current lack of buying opportunities. The fiscal cliff has the potential to create more of them.

Of course, we shouldn’t wish for a US recession but that’s close to the worst-case possible outcome, and a fairly distant one at that. What we’re more likely to witness is market volatility.

Already, US bond yields are back near historic lows and since Obama’s election, the S&P 500 is down 3%, much of that due to concerns over the fiscal cliff. As year-end approaches, we’re likely to see more volatile markets, so the opportunity to buy cheap US stocks (see Ripe for the picking: Overseas stocks to buy now should increase.

As for local consequences, that’s harder to predict. If the US enters recession, the Australian dollar could go either way (it fell, rapidly, at the onset of the last US recession). If the US actually starts addressing its debt problems, the trend for the Australian dollar is more likely to be down. At that point, our constant refrains to use the high local dollar to invest overseas and buy local businesses with strong offshore earnings would pay off. So if you haven’t yet acted, it may pay to do so quickly—this particular window may soon be about to close.

Finally, we may get an opportunity to deploy some of the capital we’ve been accumulating over the past year in much cheaper stocks. That’s what we’re really waiting for.