lunes, 12 de noviembre de 2012

lunes, noviembre 12, 2012

Anatomy of the US fiscal cliff

November 11, 2012 3:02 pm

by Gavyn Davies

 


The re-election of President Obama last Tuesday has triggered a fairly sharp fall in US equity prices, along with a decline in bond yields. Although I argued in this blog last weekend that bonds would prefer an Obama win, while equities would prefer a Romney victory, the extent of the decline in equities in mid week came as a surprise. To some extent, the market was reacting to prospective increases in capital gains taxes, and to tighter regulation of the financial sector, in the President’s second term. But undoubtedly the main factor was uncertainty about the fiscal cliff.





Most investors are assuming that Washington will agree to postpone most of the fiscal tightening which is implied by the “cliff”, but only after prolonged negotiations which could continue past the initial deadline at the year end, when the lame duck Congress departs from the Hill, and which might even be extended past the President’s inauguration on 21 January.





The standard assumption is that the outcome will involve a fiscal tightening of 1 per cent of GDP next year, which is enough to keep GDP growth well below trend, but not enough to cause a recession. But there are many other possible outcomes which are likely to keep investors very nervous until this is finally settled.
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The “cliff consists of a series of tax and expenditure measures which have already been legislated to take effect on 1 January 2013, and which taken together would tighten fiscal policy by $502 billion in 2013, and $682 billion in 2014 (3.9 per cent of GDP). Legislation has to be amended if this is not going to take place, which is why both parties have the ability to block progress. Unless the House Republicans agree on a compromise with the Senate Democrats, and the President, this fiscal package will be automatically triggered.
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Furthermore, the federal debt ceiling needs to be increased in the next couple of months, which also gives the House Republicans the kind of blocking power they used in July 2011.



There are five main elements in the composition of the cliff. To simplify information which has recently been published by the Congressional Budget Office, they are the following:








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Focusing on the 2014 figures, cuts in defence (item 1), medicare and other government spending (item 2) amount to $112 billion, or 16 per cent of the overall tightening.




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The ending of the Bush tax cuts on lower and middle income groups (item 3) accounts for $382 billion, or 56 per cent of the total. The Bush tax cuts for upper income groups, which is by far the most politically contentious area, amounts to only $38 billion, or 6 per cent of the total. That leaves $150 billion (22 per cent of the total) coming from the ending of the payroll tax cuts, and the emergency unemployment benefits which were agreed in 2010.



The CBO has also estimated the economic impact of each of the separate components of the cliff. This is what the results look like:





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The overall impact on US GDP next year, if the entire cliff were to take effect, would be to reduce real GDP by 2.9 per cent, and reduce employment by 3.4 million jobs. No wonder the markets are worried.




However, while both parties agree that a large fiscal tightening will be needed in the long term to ensure sustainability in the public accounts, it does not appear that either party wants to implement all of this tightening in 2013. The argument is over which part should go ahead, and which part should be postponed. By far the most difficult bone of contention is the smallest item, the Bush tax cuts for the upper income groups. Ironically, the CBO figures imply that this item would have almost no immediate impact on the economy.




The House Republicans have repeatedly argued that there should be no increase in marginal tax rates, though the Speaker John Boehner appeared last week to suggest that some other form of revenue increase might be acceptable to him. The President, in contrast, believes that he has a decisive electoral mandate for tax increases on upper income families, and does not see why he should lose this debate. He is being encouraged in this by many of his political allies. A possible compromise could be to apply higher tax rates on families with annual income of (say) $ 1 million a year, rather than the $250,000 a year which the President discussed in the election campaign.




Other items might be much easier to agree upon. Both sides seem ready to accept that this is not the right time to increase taxes on lower and middle income groups, so the elimination of item 3 seems probable. On the other hand, there seems relatively little support for extending the reliefs in item 5, so this area of tightening may well survive. Finally, some part of the tightening in items 1 and 2 might be necessary to placate the House Republicans, who are eager for spending cuts.



This would produce an overall fiscal tightening of about $200 billion, which is the 1 per cent of GDP assumed by the markets. On top of that, there may be more fiscal tightening in the pipeline, stemming from reductions in spending by state and local authorities. J.P. Morgan economists said this week that this may result in an overall fiscal tightening of around 2 per cent of GDP in 2013, which is more than the market expects.



Finally, what would all this do to the longer term outlook for US public debt? If the fiscal cliff is allowed to take full effect on 1 January, then the path for federal debt held by the public would follow the CBObaseline policyshown in the chart below:








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Under this baseline (blue line), the debt ratio would peak at 76.6 per cent of GDP in 2014, and then decline to 58.5 per cent in 2022. The US debt crisis would, in effect, be over, though the economy would probably fall into recession in 2013.



At the other extreme, if almost all of the cliff were postponed indefinitely, then the debt ratio would continue to rise rapidly, reaching 90 per cent by 2022 (red line). Something in between these two extremes appears to be needed.




If the compromise plan outlined above were implemented for two years, followed by full implementation of the cliff when the economy is assumed to have recovered in 2015, then the debt ratio would follow the green line. This seems like a sensible compromise between the need to boost the economy in the near term, and the imperative to control debt in the longer term.




The markets would like it, even though there would be legitimate doubts about whether the American political system would actually be able to impose the fiscal tightening when 2015 comes around.




Can Washington agree to such a compromise? Probably, but only after a lot of political wrangling first.

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