Imagine a train speeding down a track, just a few miles away
from a wall that it will crash into. You can't see the wall yet,
but you're told it's there anyway. As the train chugs down the
track, the wall gets closer until it comes into view. Before long,
that wall appears bigger and bigger until it is right in front of
the train. By that time, there's no way to stop the train in time
and you can only hope that the damage isn't catastrophic.
That's the game Washington is playing with our
Policy makers have frittered away ample opportunities to address
our nation's soaring budget
, failing to agree on a package of spending cuts and tax hikes that
will close the gap and avert a crisis. Now, as we head into the
summer, the budget deficit remains quite large, and the train is on
auto-pilot. By the end of this year, a range of automatic spending
cuts will kick in and a series of tax breaks will expire, leading
to the newly-popular phrase "fiscal cliff."
Should you be concerned? If you have a stake in the U.S. economy or
have funds in the stock
, then yes, you should be very concerned.
A huge brake on the economy
Believe it or not, the stunning run of budget deficits during the
past decade has actually been good for the economy. It's simple
math. The government has pumped more money into the economy than it
has extracted, which has supported all kinds of sectors from
defense to healthcare to technology to education.
We can all agree that it's wise to eliminate our budget deficits so
we don't leave an even bigger mess to the next generation, but it's
crucial to understand that reversing our nation's massive
, which now exceeds $15 trillion, means that the government not
only needs to cut spending in line with tax revenues but actually
to a level below that to start paying down the debt. It's as if the
government will put its foot on the economy's brakes for a long
time to come.
Before I go any further, let's take a moment and think about just
how big a number that is. Sometimes we tend to get desensitized to
large numbers, so let's take a look at the actual number to
understand just how many zeroes we're talking about:
$15,000,000,000,000. [For an even scarier picture, take a look at
the U.S. debt
But we're not even talking about that just yet. Right now, we're
trying to figure out how to balance a budget, let alone run a
surplus. To start that process, those automatic spending cuts and
tax increases will kick in on Jan. 1, 2013. How much money are we
talking about? $600 billion. Sadly, not only might that force an
already-weak economy into
, but it won't even completely close the budget gap.
That $600 billion equates to roughly 3.5% of gross domestic
product, which means it would take an economy growing at that rate
down to zero growth. An economy growing in the 1.5% to 2.5% range
in 2013, which now looks increasingly likely, means the 3.5% drag
would push us into recession. And as we're seeing in Europe,
economic contraction reduces government revenue, making the goal of
a balanced budget even more elusive.
Don't think this is an issue to worry about in six months. Analysts
at Societe Generale (SoGen) predict the "uncertainty surrounding
the cliff will remain unresolved at least until November, and
possibly until early 2013. This could begin to weigh on growth in
the second half of 2012."
If there's a will, there's a way
Now that we're all sufficiently scared, let's take a look at how we
might avert such a mess. As of now, Republican members of Congress
appear disinclined to strike a deal with President Obama on hopes
thatRepublican presidential candidate, former Massachusetts Gov.
Mitt Romney, will win the election in November and they can craft a
more appealing deal after that. After the election takes place, a
short-term extension that buys more time will likely be agreed
upon, regardless of who occupies the Oval Office next January. At
that time, the process will also begin to more seriously address
the long-term deficit.
Let's run through the two scenarios...
An Obama win
If president Obama wins the election, then a number of members of
Congress are likely to realize that four more years of blocking
tactics would surely lead us to some sort of fiscal Armageddon. The
markets have shown remarkable patience as we've run up deficits so
far, but further deficits are likely to trigger an exodus of bond
buyers as they come to doubt whether Uncle Sam will ever meet its
obligations without some sort of write-down. As a result, some
taxes will be raised, or at least some tax loopholes will be
closed, perhaps in line with the recommendations of the
Simpson-Bowles task force
Some of these loopholes involve corporate taxes, such as tax
credits for research and development initiatives. Yet some of the
loopholes may hit consumers directly, as I noted last year
in this article
A Romney win
It's crucial to distinguish between Mitt Romney the politician and
Mitt Romney the free enterprise advocate. The former has taken
stances that will secure votes, while the latter is interested in
creating the most stable backdrop for businesses. That means a
clear plan to tackle the deficit, which even Mr. Romney would
concede in a private moment, cannot be done with spending cuts
In effect, Washington is likely to get serious about a solution in
the first half of 2013, which should boost the investment climate
for businesses. Yet as noted earlier, such a climate, by
definition, entails a drag on the economy.
My prediction: The current program of extended unemployment
benefits and payroll tax cuts (worth around $125 billion annually)
will not be extended. Nor will the Bush-era tax cuts for households
making more than $250,000 ($75-100 billion). However, an extension
of the Bush-era tax cuts for households making less than $250,000
(nearly $100 billion by fiscal 2014, according to the Congressional
Budget Office) will likely get continued bipartisan support.
Risks to Consider:
This analysis assumes that cooler heads will EVENTUALLY
prevail, but Washington has snatched defeat form the jaws of
victory many times before.
Action to Take -->
Inaction is not an
. Regardless of the ultimate solutions devised, we already know
what investments to avoid. As I noted
in this article
, defense stocks and other companies that do a lot of business with
the government may suffer a great deal of pain in coming years as
You can no longer afford to ignore this issue. As noted earlier,
fears of the looming fiscal cliff may start to impede economic
growth as early next quarter as companies start to defer long-term
spending. Track events closely to see what type of eventual
compromise may take shape. In an ideal world, Congress won't wait
until the lame-duck session after the election and will take action
earlier. But to paraphrase a former government official, "we're
stuck with the Congress we have, not the one that we want."
-- David Sterman
P.S.-- Warren Buffett, Goldman Sachs, John Kerry... maybe even
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David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.