Fiscal Cliff: What to expect and how the market may react

Remember, often the stock market's reaction to a positive outcome is negative. The share market fell after TARP in 2008, the Spanish bailout, the last US mid-term elections and after the presidential election

The world seems to be a much safer place. Several stock markets are just slightly off their 52-week highs. Many of the world’s problems appear to be solved, but they may just have passed out of sight. Europe is still in a severe recession. China’s slowdown apparently bottomed, but the renewed growth is due to factors which will make its bad debts, real estate bubble and shaky banking system worse. Still these little issues are being ignored. The one major concern is the coming calamity in the US, known as the “fiscal cliff”.


The fiscal cliff is an imaginary deadline, but one with real consequences. It is the result of an earlier stalemate and continues for the same reason. Ten years ago during the Clinton administration the debt of United States stood at about $6 trillion or about 60% of GDP and revenues exceeded expenditures as a percentage of GDP (gross domestic product). Thanks to wars and tax cuts during the Bush administration and stimulus spending and lowered tax revenues from the recession during the Obama administration the debt now stands at over $16 trillion and is climbing to near 100% of GDP.


Under US law the Congress sets a ceiling for the US debt. To allow the US Treasury to cross the ceiling and institute a higher one takes a vote in Congress. With the houses of Congress divided between the two parties, Republicans and Democrats, either party can block the agenda of the other and are exceptionally happy to do so. So when the debt needed to be raised in August 2011, the negotiations came down to the last possible moment. The compromise was that the debt would be allowed to rise, but if there was no future compromise, on 2 January 2013 there would be a dramatic rise in taxes and a severe cut in spending. The result would be about $600 billion in savings. The reason for the deal was that both parties felt that by 2013 the elections would give power to one party or the other. Instead the elections decided nothing. It just delivered the status quo.


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The fiscal cliff has two aspects. Basically it is a severe program of austerity of the type that the EU (European Union) is forcing on the EU’s peripheral countries like Ireland, Spain and Greece. The program would cut the budget deficit in half. Even with the fiscal cliff, the US debt is likely to continue to grow, but the projected increases in the debt would be lowered by as much as $7.1 trillion or about 70%. With lower debt, the US economy would be in much better shape, but the impact of large spending cuts and tax increases would reduce the GDP potentially putting the US into recession. The depth of the reduction is subject to debate. The Congressional budget office is predicting a slow descent into a -1.3% contraction. However the effect of zero interest rates could push the contraction down to - 2.2% and the unemployment rate up to over 9.1%. The recession would be avoided if Congress found a different solution, but any less drastic solution would simply push the problem further down the road most likely resulting in higher debt and slower growth.


The other reality of the fiscal cliff is that there is more than one. Besides the spending cuts and tax rises, the Congress needs to authorize another rise in the debt ceiling. In addition at the beginning of the crisis, Congress authorized a temporary guarantee of certain non interest bearing accounts held in US banks. The amount of money in these accounts (TAG accounts) is huge—about $1.5 trillion, or 13% of bank assets. This program ends on 31st December as well.


The odds of a deal by 31st December are slim. President Obama wants to raise taxes on the wealthiest 2% of Americans, but he wants to protect the expensive entitlement programs. Of the 287 Republican members of Congress all but 13 have taken an oath not to raise taxes. The election was bitterly fought on this issue at a cost of $6 billion and little was decided. The president, who ran on the issue, feels he has a mandate. The Republicans who retained most seats have no reason to change.


The only real power that could get the legislators to compromise is the market. In October 2008 after the Republican House failed to pass the stimulus program (TARP), the market dropped 800 points. However market reaction to political deals can be even more negative. Markets dropped after TARP, after the debt ceiling deal in August of 2008, after the Spanish bailout, after the last US mid-term elections and after the recent presidential election. So although many are expecting a rally if there is resolution, the evidence suggests that reality could be worse than uncertainty.


To read more articles by William Gamble, click here.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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