Friday, November 2, 2012

The US election and fiscal cliff

Elections are always important, but next week’s US Presidential election is more critical than most, at least for near-term fiscal policy.  At issue is the so-called “fiscal cliff” and the unlikely event that inaction from policymakers will see a significant increase in fiscal contraction in 2013 as tax cuts expire and automatic spending cuts (sequestration) begin.  What we don’t know is what action will be taken to avert the cliff and when that action will be taken.  The uncertainty will start to be lifted as we find out next week who is in charge in the White House.

Of course whoever the President will be come January is only part of the political equation.  The question I get asked most frequently at the moment is who I would prefer to see in the White House.  The more important question for me is the strength of the President’s mandate.  That will be determined by whether he has both, one or neither of the House or the Senate.

Since the mid-term elections in 2010, President Obama has had to manage a divided Congress.  Recall it was at that point the Democrats lost the House but retained the Senate.  That has made it difficult to make decisions and enact legislation as witnessed by the debacle of last year’s debt ceiling debate.

It seems unlikely that we will see a President emerge from the election with a united Congress, although Romney probably has a slightly better chance of achieving that than Obama.  So it seems most likely that we will see a President with a divided Congress.  Of course the other possibility is a President with neither the House nor the Senate.  That will make implementing the President’s legislative program somewhat fraught.  We will know soon.

The good news is that both Democrats and Republicans appear united on a number of the fiscal cliff elements that will need to be agreed on in pretty quick order.  For example it seems likely the Bush tax cuts get extended in totality (Romney), or at least in part (Obama).  It also seems more than likely that the Payroll Tax Cuts and the Unemployment Insurance will end.  As you would expect, there will be most vigorous debate around the programmed spending cuts.  We think decisions on at least that part of the “cliff” will get kicked down the road.  Based on those assumptions we think the fiscal drag on growth increases from around 0.7% of GDP in 2012 to1.3-1.5% in 2013.

All things considered (or at least as best one can consider things right here and now) I’m still happy with my 2013 US GDP forecast of 2.0%.  The good news is that the politics of the fiscal cliff and then the implementation of a greater degree of fiscal contraction next year will be playing out at a time when US economic fundamentals are starting to look, if not stronger, at least more stable.  The improving housing market is having a positive impact on consumer confidence and the stability of consumer spending.  It also appears increasingly the case that the recent slowdown in global growth is starting to bottom out, supporting our view of a modest pick-up in global growth next year.  On the downside, however, we know businesses have been delaying hiring and investment decisions on the back of fiscal uncertainty.  That will continue to be a drag on growth until the fiscal landscape is more certain.

Another near term complication is that Congress will need to raise the debt ceiling again soon after the election.  The current limit of $16.4 trillion is likely to be reached by around year-end.  The Treasury can buy some time by disinvesting federal employee retirement funds, but that will only ever be a very temporary measure and would only delay the inevitable to February or March at the latest.  How that plays out will depend on the political landscape after the election, but I also think the politicians were taught a valuable lesson by the rating agencies and the public outcry during and following last year’s debate.

Once the near term fiscal landscape becomes clearer there will still be a couple of not-insignificant issues to think (worry?) about.  The first is monetary policy under a Romney Administration.  The Republicans have been critical of recent Federal Reserve policy action.  Romney has already committed to not reappointing Ben Bernanke when his term expires in 2014.  That and the implications for quantitative easing would become an issue for markets at some point.

The other issue is fiscal policy over the longer term.  Fiscal cliff resolution will not address the bigger question of US long-term fiscal sustainability.  That requires a credible long-term fiscal plan.  All we know at this point is that a long-term fiscal consolidation plan authored by Mitt Romney is likely to be heavy on spending cuts, while an Obama plan would be more balanced between lower spending and higher revenue.  Either way, it was the absence of such a plan in Europe that made the Euro zone debt crisis worse than it needed to be.  Take note, America.