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In assessing January’s so-called “fiscal cliff,” we suggest the greatest risk may lie in the remedy.

As we reach the one year anniversary of our “Tug of War” investment theme, a reread confirms that the passing of time has yet to render it irrelevant. The notion that markets would be attune, if not myopically focused, on government’s continual struggle to address gross fiscal imbalances is as pertinent as it was a year ago – if not more so.

One would have reasonably expected the past twelve months to bring a more concrete resolution. Instead the setting of various limits and deadlines has proven fertile ground for immense creativity, leaving the proverbial can subject to one swift kick after another. However, the notion of an impending fiscal cliff suggests that January 1, 2013, will mark an abrupt end to the well-traveled road of conveniently ignoring mounting deficits. The image is more dramatic though. It also suggests something is destined to fall into the abyss.

Readers will recall the two primary events that have created this so-called cliff. First, a host of tax cuts initiated by George Bush in 2001 and later extended by Barack Obama in 2010 “sunset” (a particularly gentle term for “expire”) at the end of 2012. Second, as a concession for cajoling Republicans to raise the debt ceiling last Fall, a bipartisan Super Committee was charged with cutting just a sliver from the budget. Consistent with a predetermined agreement, the committee’s inability to find common ground forces across-the-board budget cuts effective in 2013.

While additional tax revenue and reduced spending would be seemingly welcome news for deficit hawks, there are mounting concerns that adopting some measure of austerity would be particularly detrimental to a struggling and fragile domestic economy.

The extent to which the simultaneous events will hurt the economy is a matter of debate. Estimates for the expected reduction in economic growth range from 1-4%. With next year’s muted growth estimates only in the 2-3% though, the concern is that the coupling of less government spending and higher taxes will leave the economy flirting with the often mentioned double dip recession.

The threat is not lost on Fed Chairman Bernanke. He has made it clear there isn’t anything his committee can do to help the economy avoid economic contraction without Congressional cooperation. It is worth noting that in the next breath he is equally emphatic in his resolve to print more money if necessary though, the layman’s description for another round of quantitative easing.

With a metaphor like “the massive fiscal cliff,” we can expect the pending legislative changes are going to be sensationalized. Even though readers of this blog are well aware of our long-standing belief that the nation’s fiscal troubles are not being taken seriously, this particular threat is unlikely to forewarn of the Armageddon suggested. The primary risk of the so-called cliff is not that fiscal policy will singlehandedly cause the economy to plunge into the aforementioned abyss. Politicians are simply unlikely to make financial decisions that hurt the well-being of the constituents who determine their employment status. The fact that international creditors are still accepting artificially low yields on our debt and “only” one independent agency has lowered the credit rating of the United States will deceive politicians and constituents alike into believing that austerity can wait another day.

Instead, the more likely risk is that the looming changes will invite months of political brinkmanship and an eventual postponement of meaningful austerity, allowing for the cultivation of additional debt in the name of averting recession. The hope is that there must be a better time to implement fiscal restraint – or at least a more favorable political climate to stick the bill to a democratic minority. The reality is that an ideal time to implement fiscal discipline will never materialize yet the cost will compound in the meantime. Additionally, the credit rating agencies may be unimpressed with both the bickering and creative games employed to circumvent fiscal realities, raising the specter of another credit downgrade.

The prudent investor recognizes it is only reasonable that there is an inherent trade-off here. Deficit spending and interest rate manipulation may very well serve to skirt immediate reckoning but it simply can’t continue indefinitely without consequence.