We may have our doubts about Ben Bernanke’s skills in monetary policy, but he certainly has a yen for memorable phrases. The latest term he has coined — the “fiscal cliff”—describes what would happen to the US budget if current law played out with no political intervention. On January 1, 2013, the Bush tax cuts expire, the 2% payroll and other tax holidays expire, and at the same time as these effective tax hikes, automatic spending cuts are scheduled to kick in as a result of last year’s Budget Control Act and the failure of the committee to produce a more targeted debt reduction plan. The combined fiscal hit is estimated at $1trn in 2013 & 2014 (most comes from the tax hikes). Politicians and bureaucrats on both sides of the fence agree that a recession would be all but unavoidable in such an event, even if the resulting decline of the public debt trajectory would be beneficial in the long-term.
But this “fiscal cliff” is protected by an imposing political guardrail. We think it is very unlikely that the political establishment will allow the US economy to take a $1trn fiscal plunge. Instead, the above-mentioned laws will be extended beyond Jan 1, 2013, regardless of who wins the election.
To see why consider the three possible election outcomes:
1) President Obama is re-elected, and Democrats gain control of Congress (unlikely but conceivable)
The last thing Obama would want to do in this situation is sabotage the economic outlook for 2013, when Democrats will be seen as entirely responsible. Obama would want to revise the tax code to raise taxes on the rich but this would be impossible in the lame duck Congress. If Republicans insisted on temporarily extending the entire Bush tax cuts, Obama would not veto this. Instead he would maintain the Bush tax cuts to keep the economy afloat and hope to achieve comprehensive tax reform in the new Congress. The same would apply to the sequestration process (i.e., automatic budget cuts). Deficit reduction would be delayed until comprehensive tax and spending reform could be agreed by the new Congress. Even in the unlikely event the lame duck Congress refused to raise the debt ceiling, would a temporary default matter, since everyone would know that the debt ceiling would be raised the day after inauguration day?
2) Mitt Romney wins and Republicans gain control of both houses (more likely than Scenario 1)
In theory Obama could veto an extension of the Bush tax cuts and a postponement of the sequestration process, pushing the economy off the fiscal cliff. But this would be seen as a blatant exercise in political sabotage by a president who had just been defeated in an election. Would Obama really openly defy the will of the people in this way? And even if he did, would it matter, since the new president and Congress would reinstate the Bush tax cuts and sequestered defense spending immediately after inauguration day. As in (1) above, the only politically rational and democratically justifiable course would be to extend all the legislation (including the debt limit) for another six months or so, to give the newly elected president and Congress the chance to implement their new mandate.
3) Obama is re-elected but Republicans maintain or increase their control of Congress (this is the most likely outcome)
This scenario would imply continuing fiscal gridlock, but neither Obama nor Congress’s Republican leaders would want to be responsible for sabotage. So the most likely outcome is that the re-elected leaders would behave in much the same way as they have in the past four years—they would again vote to postpone the fiscal day of reckoning.
In all three of the scenarios above, the Congress and the president would have the best possible excuse for temporarily extending all the current legislation: it would obviously be absurd and undemocratic for the biggest fiscal decisions in modern US history to be rushed through in one month of legislative chaos, by a Congress and President whose mandate has just been overturned by the voters.
To us, the only real factor that could change the dynamics is a revolt by bond market vigilantes, pushing bond yields to 4% or above, and forcing more decisive action to lower US debt levels.
The next question is whether or not the markets agree with us that politics will not allow for a drastic change in revenue policy. If the answer is yes, then US equities should consolidate recent gains. But the uncertainty leading up to the decision (sure to occur at the last minute) will likely make some nervous enough to buy protection. And while we do not see it as very good protection over the medium term, many investors are likely to take shelter, once again, in US Treasuries—thereby keeping rates subdued. As long as bearish investors keep bond yields in the 2-4% range, it is inconceivable that a lame duck Washington will be forced into emergency fiscal tightening by bond vigilantes. Many investors argue that the fiscal cliff means US interest rates will be heading even lower – but the only possible way for US bond yields to get from 2% to 1%, is via 5%.
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