Review & Outlook

Our take on the investing, financial, & economic themes of the day

The “Fiscal Cliff” that Isn’t

18 December, 2012 by Ben O'Brien in Commentary

The first thing to get clear about the “fiscal cliff” is that this term, unhappily coined by Federal Reserve Chairman Ben Bernanke, is misleading.  There isn’t really any fiscal cliff, no matter how much the news media, with its relentless 24-hour news cycle, likes to sensationalize the idea.  Rather, there is a gradual fiscal slope, which we have already been sliding down, by fits and starts, for some time.  This slope inclines towards an unsustainable policy of government spending and borrowing.

The upshot is that we do not face a “do or die” moment that the cliff metaphor suggests.  We face a gradual and complicated series of decisions about fiscal policy, which arose before the 2008-2009 financial crisis, and whose consequences can be uncertain and often delayed.  Slopes, unlike cliffs, are forgiving.  We can stop our descent merely by turning around.  There is good reason, therefore, for investors to avoid trying to “play the cliff”—that is, making any major moves into or out of the market based upon speculations about the outcome of current negotiations between the White House and Congress.  The December 31 deadline to alter the $500 billion package of automatic tax increases and spending cuts creates urgency for the politicians whose job it is to compromise on prudent legislation; but it doesn’t create urgency for investors in U.S. financial markets.

It’s arguable that the slide down the fiscal slope began all the way back with the Bush-era tax code.  When President Bush succeeded in reducing federal income tax rates, he was unable to marshal enough congressional support to make the cuts permanent, so they were set to expire automatically unless Congress and the president chose to renew them.  President Obama reluctantly extended the tax cuts once, and now they are again set to expire on December 31 and taxes increase on January 1, 2013.  The uncertainty inherent in this arrangement makes U.S. fiscal policy as a whole more uncertain, because it becomes more difficult to gage tax revenues for the government and tax liabilities for individuals and businesses.  Moreover, 2008 and 2009 witnessed massive increases in federal deficit spending with various bailout and stimulus programs proffered by both Bush and Obama in response to the financial crisis.  The economic recovery since that time has been tepid, although the stock market has returned almost to its pre-crisis levels.

Another slide further down the slope came with the debt-ceiling crisis, which came to a head during the summer of 2011 when Congress raised the limit on borrowing by the Treasury and the credit rating of the U.S. was downgraded by Moody’s.  The Treasury’s increased borrowing will fund current government spending past December 31 and until early 2013, when Congress and the president will again have to decide whether to raise the debt ceiling.

In addition to the tax increases that are set to take place on January 1, there are also a series of mandated federal spending cuts—or rather, decreases in the rate of spending increases.  (A slower rate of increased spending is what the government means by a “cut.”)  A further reason why such events do not amount to a “cliff” is the possibility of a retroactive solution.  Even if December 31 comes and goes without any deal between the White House and Congress, it will still be possible to pass legislation later in January that adjusts taxes and spending retroactively from the first of the year.

It is unknowable how the market will react in the short-term to the partisan wrangling of the next several weeks.  The market may drop sharply if Congress and the White House fail to reach a compromise by December 31, which then may spur them to craft a retroactive solution that causes a big market rally.  Whether this happens, or something else entirely, it remains true that the apocalyptic metaphor of a fiscal cliff mischaracterizes our situation.  To be sure: the indebtedness of America is a serious problem.  Credit cards, student loans, unfunded state pension liabilities, and the federal debt pose real threats to the fiscal health of the United States, and our politicians have avoided addressing these threats head on.  As worrying as America’s indebtedness is, however, it doesn’t mean that we are in danger of falling off a cliff on December 31.

 

Matthew B. O’Brien, Ph. D