Driving Over the Fiscal Cliff

With Friday's deadline for the sequester now past, it might be time to take stock of how this whole Fiscal Cliff matter was resolved.  You'll recall, Ben Bernanke first coined this term in respect to several contractionary forces that faced the US economy at the end of 2012.  These items included the sequester, the expiration of the Bush tax cuts (including dividend and capital gains), the expiration of the payroll tax cut and the imposition of the Obama health care tax.

The months leading up to December 31st were filled with great theater, fueled by the Obama administration's fear mongering and the gravitational pull toward sensationalism by the news media.  Reports were widely circulated that the Fiscal Cliff would result in some $600 billion of combined spending reductions and tax hikes, enough to snuff out a fragile economic recovery and send unemployment soaring. JP Morgan broke out the effects of the various tax and spending items on its forecast for 2013 GDP as follows:

At year end, America breathed a collective sigh of relief as politicians reached a stumbling, bumbling eleventh hour aversion to the crisis, as the always weepy Boehner knuckled under while the triumphant Obama prevailed on his new found goal of deficit reduction through tax hikes for the wealthy.  Nothing much else happened at year end, other than the tax hikes and of course, a swift punt of the remaining issues to a later date.

Surprisingly to us, economists, politicians and pundits alike now cheer the outcome as we tipped away from the precipice.  But now, less than 90 days later and taken in the context of Friday's relatively uneventful start to the sequester, it might make sense for us to re-examine what really happened up there on that cliff.

Of the four elements to the cliff (tax hikes on the middle class, tax hikes on the wealthy, expiration of the payroll tax cut, imposition of the ObamaCare tax and the sequestration) all, with the exception of the tax hike on the middle class have now taken place.  From a total of $600 billion in projected fiscal drag, perhaps as much as a total of $400 - $450 billion of these measures are now in effect.

So, by most measures, we went over the cliff.  Albeit, from lower elevation than we had been warned, but still likely high enough to hurt.  Add to the pain, the projected $150 billion in further drag from higher gasoline prices and it looks like we're going to get a good peak at just what was beyond that cliff after all.

Don't Fight the Fed

The Federal Reserve Bank recently issued its forecast for US economic activity for 2013.  The Fed continues to walk the delicate line of reporting soft growth and weak unemployment, thereby supporting their unbridled monetary zeal, while at the same time projecting sunny skies ahead.  In the din of Wall Street trading rooms, once enlivened by ringing telephones and shouting traders, all that can now be heard amidst the clicking of keypads is the occasional mantra uttered by a young trader under his breath, "don't fight the Fed", "don't fight the Fed".

That spark of trading ingenuity, coupled with the equally insightful advice "buy the dips" has worked superbly as a trading strategy for equities over the past four years.  Gone are the days of bottoms up analytical rigor and valuations analyses.  These sorts of 'old school' things are still done, quaint as they may be, but who has the time to pay attention?  If the Fed is still pumping, then you betta be a humpin.  BTFD.

This strategy will continue to work until one day it just doesn't.  No one will know why, but it just won't.  Then, as now, investors will continue to buy the dips in an attempt to average down the cost of positions, but this time it will be in vain.  Prices will continue to edge lower.  Undeterred, the buying will continue until investors are fully invested.  Then the selling will start to escalate and the buy the dip crowd will eventually capitulate, unable to bear the ever growing red numbers on their trading screens. Welcome to the new bear market.  In hindsight, everyone will be pointing to the bubble in equities, the bubble in Treasuries and the crazy scheme of the Fed to prop up prices with QE.

Investment banks have teams of Fed watchers to prevent just this sort of thing from happening.  News media interview guests who speculate on the actions, if not every word of Ben Bernanke, only to post-script and de-brief after every Fed meeting, interview and speech.  Aside from divining direction, though, we ask the question how much insight the Fed really has and much can this organization really tell us.

If we look back on the Fed's record of market forecasts, they're questionable at best.  In early 2009 the Fed predicted that GDP for the year would decline 0.9%.  It actually declined 2.60%.  That's a margin of error of 189%.  For 2012, they forecast 2.45% growth at the beginning of the year, only for the US economy to see something on the order of 1.85%.

Over two years, their forecasts are even worse.  In early 2011, the Fed forecast a one-year GDP number of 3.65% (actual of 1.70%) and a 2012 GDP number of 3.95% (versus 1.85% actual).  Note also, that each of these egregious errors of forecasting was uniformly to the upside.  No accident there.

Add to this the fact that five years of Fed engineered zero interest rates and three trillion dollars of QE have failed to restart the economy and it has us really scratching our heads.  With a record like that, we have to ask why anyone would place confidence in such an institution.  Maybe someday.  But for now, we'll just put our heads down and murmur the mantra like everyone else.

Obama 2.0

With the inauguration of President Obama's second term upon us, we thought we'd take stock on the governance of his truly unorthodox administration.  First, let's define unorthodox.  Throughout the 20th Century US Presidents have been moderates, either moderately liberal in the character of Jimmy Carter and Bill Clinton or moderately conservative in the policies of George Bush senior and junior.

Barak Obama, however, most would agree breaks the mold and sets a new direction of extreme ideology for America.  Many of course support this vision, as evidenced by his solid victory last November over his moderate challenger, Mitt Romney.  Be that as it may, it would be hard to argue that Obama is a centrist or one who is seeking to lead by unifying America across political lines.  You may love him, you may hate him, but by now everyone understands him.

Obama speaks extensively about equally.  He speaks about the great and growing divide between the rich and the poor, income inequality, tax policy and his vision of fairness. Supported by uber-wealth and self-effacing Warren Buffet, he argues that America should put an end to tax breaks, low tax rates that enable Mr. Buffet to a pay lower tax rate than his secretary.  After all, let's be fair about this.

It's inarguably true that income disparity has grown in America, a subject which we've written about before.  It's also patently clear to everyone by now that President Obama is determined to rectify this problem.  The much herald fiscal cliff was resolved weeks ago with no expenditure increases and substantial tax increases - win/win you might say for the Democrats.

And so we ask, what is likely to come of all this new tax policy?  Well, as anyone who is paying attention learned quite readily from the tax returns of Mitt Romney and sifting through the rhetoric of Warren Buffet, the truly rich amass a very small fraction of their wealth through ordinary income.  Despite all the populist banner waving of Buffet, this is the reason why his effective tax rate is lower than his secretary.  It's not a mistake, it's not the unfairness of US tax policy and it's certainly not by accident.

Thus, the recent and seemingly relentless effort to raise taxes on the rich has two fundamental flaws.  First, the ultra rich grow their wealth only modestly by current income (and therefore higher tax rates have only minimal impact upon their wealth) and two, any greater tax revenue that the government derives from higher taxes does little to improve the lives of the middle class.  That is the subject perhaps of another blog, but there is zero evidence that government deploys greater tax revenue to reduce taxes on the middle class. Rather, greater tax revenue simply grows the size of government.  You see, there are actually three parties at the table, not two.  And the government has its own needs.

But if tax rates go up certainly someone must lose?  This is correct.  But it's not the ultra wealthy billionaires who have more than enough to go around.  These people by design have minimized their ordinary income (Warren Buffet, of course, included). The group who loses the most is the aspiring affluent class, the upper-middle class who has over achieved in their aspiration to become wealthy.

It is this group, more than any other who is at the greatest risk for adversity under the Obama administration. The problem with redistributing wealth through tax policy is despite all our political hand wringing and teeth mashing, America has never found a way to confiscate existing wealth.  This leaves the far left perplexed and frustrated and forced to settle for lowering the living standards (i.e. limiting inequality) not of the truly wealthy, but of those who aspire to be.

Fed Returns $89 Billion to US Treasury

We were struck by this bold and encouraging headline from yesterday's news.  Wow, what a performance for the Fed.  On behalf of US taxpayers, thanks a million er, billion!  How did you guys do it, anyway?

Well, to answer this simple question we need to understand the Fed balance sheet and its policy of open market purchases of US Treasuries.  The Fed rebates the profit it receives on its holding of US Treasury bonds back to the Treasury, net of its costs.  And since the Fed simply prints money, or reserves, to pay for the Treasuries it purchases, it has no cost of funds.  So interest income on its portfolio of US Treasuries, minus its operating costs, minus its zero cost of funds equals $89 billion.  If you want to try this at home, simply buy huge quantities of US Treasuries and pay for them with money you print in your basement.  Then all you have to do is lock your doors, avoid answering the doorbell and live off the net interest income.

The Fed has created a fancy name for this:  quantitative easing and we are now in version 3.0.  The Fed is now actively buying $45 billion of new Treasury bonds each month (plus $40 b of mortgage backed securities).  So let's review where we are and what contributed to the Fed's $89 billion windfall for US taxpayers.

First, net new issuance of Treasury bonds sold to finance the annual budget deficit for 2012, totaled $1.2 trillion.  The Fed purchased roughly 80% of that net new issuance, or $960 billion.  Total holdings of US Treasury bonds by the Fed now equal just under $1.7 trillion.  So simple math would imply that in order to rebate that juicy profit of $89 billion to the American Taxpayer, via the Treasury, the Fed debased the US dollar by pumping a total of $1.7 trillion of new dollars into the system.

Suddenly this doesn't seem like such a great deal anymore.  Watering down the US dollar for everyone to the tune of $1.7 trillion, just to earn a measly profit for the Treasury of $89 billion? Let's give this some further thought.

The total US money supply is notoriously difficult to measure, but let's use M2, generally the most accepted broad measure of money in the economy.  According to the Federal Reserve of St. Louis, M2 currently stands at around $10 trillion.  Let's assume further that the addition of $1.7 trillion in reserves has only a 1% impact on debasing this stock of $10 trillion (even though it amounts to 17% of M2).  That's still $100 billion!  So $100 billion of the purchasing power of the dollar vanished from the US economy so that the Fed could turn around and deliver a profit of $89 billion to the Treasury?  That doesn't seem too smart to us.

How Does Your Garden Grow?

A new year and some new resolutions.  So it is, at least with the fiscal cliff and the 112th congress, charged with being the least decisive, most acrimonious and least accomplished government in US history.  Digging around in the weeds of their recent budget negotiations, however, reveals just how unruly our garden has become.

By now we all know of the excesses of our past debt cycle.  We're all deleveraging and this has its contracting forces on the economy.  Well, at least most of us are deleveraging.  The Federal government is re-levering at an unprecedented rate.  The Federal debt now tops $16 trillion, up from a paltry $8.6 trillion at the end of fiscal year 2006.  In so doing, our ratio of debt to GDP has climbed from 70% to in excess of 100%.

The debt cycle of the past 25 years produced other great distortions, though, and its unwinding will be no small feat.  Inflated housing prices and artificially high consumer spending are the first to come to mind.  But the impact that this leverage has on the economy reveals many lesser known dangers, as well.

During the salad days, state and local governments saw ever rising tax revenues, prompting generous union concessions for retirement benefits.  State and local government operating budgets were built around these same lofty tax projections.  Each of these plans are now in shambles as slowed consumer spending has collapsed sales tax revenue, while lowered real estate values have crumbled property tax collections.

Colleges and universities also built future plans around seemingly limitless revenue growth.  Tuition grew so rapidly over the past twenty years, in fact, that the demand for college education was being described as inelastic (i.e., demand would continue to grow regardless of price).  After decades of unfettered tuition increases and college administrators gleefully watching parents tap the equity in their homes to pay, the party may be coming to an end.  With 30-40% of US homes with no equity and lenders tightening requirements on those rightside up, parents are beginning to push back.

The list of sectors of the economy that were artificially inflated by our debt binge grows longer.  At the same time, the Federal Reserve continues to spike the punch bowl in an effort to get the debt cycle started once again.  Meanwhile, the 112th congress has now made clear, they have no intention of being singled out as the party-poopers by putting the brakes on spending!

What last month's budget squabbles did reveal, however, is the frighteningly narrow range of solutions for reigning in the national debt.  The whole enchilada of income tax increases that Obama sought (and ultimately settled for less) would have registered only $42 billion in annual revenue.  Ending the mortgage deduction, sacrilege to many, would only raise an estimated $92 billion.  Limiting the deductiblity of employer provided health benefits, only an estimated $110 billion.

Looking back nostalgically on 2006 when the Federal annual deficit was a mere $248 billion, these tax measures each in their own would have been considered meaningful.  But with the deficit for 2013 again predicted to be in excess of $1.1 trillion, taken in their totality they hardly appear even significant.

Nancy Pelosi and the Dismal Science

Arguably the most interesting quote springing from our nation's capitol over the past several years was the now infamous Nancy Pelosi's remark on Obamacare:  "We have to pass the bill to find out what's in it".  Poor Nancy was ridiculed for a comment that, ironically, may have shown great insight into the inner workings of our federal government.

She's now at it again, but in a more subtle context in offering her guidance on the Fiscal Cliff.  We're paraphrasing, but it was something to the effect of "we all know what needs to be done: raise taxes, promote growth and cut spending".  We could hear the snickers from economists as this seemingly bipartisan but economically paradoxical statement was offered.  What Nancy failed to grasp is what every Econ 101 student learns, that higher taxes and lower spending do not produce growth, at least not in the short term.

The fiscal cliff, as we are calling it, is thus a choice between austerity and stimulus.  Since our fiscal stimulus cannot be paid for from revenue, it is also a choice between austerity and debt.  To avoid the cliff in its fullest sense, would therefore require postponing (yet again) the measures to which gave its rise.  This would mean reauthorizing the Bush era tax cuts, the payroll tax cut, capital gains and estate tax provisions, while kicking the can down the road further on spending cuts, by postponing the sequestration measures. 

This solution would cause the least fiscal drag in the short run.  Essentially, the fiscal cliff would be resolved with no more fanfare than the Y2K problem.  The concern, though, is that by punting our fiscal issues down the road it will magnify them in the long run, as deficits continue to spiral out of control.  The equity markets would like rally on the news, however, as many have suspected the market to be trading for quite some time more on government intervention than economic fundamentals.

The other extreme solution is to do nothing.  This would produce the greatest short term negative impact on the economy, but also slice the federal deficit in half in one-year.  This would also likely cause a deeply negative reaction in the stock market.

The argument that's ensuing in Washington, then, is between taking on some fiscal discipline in the form of higher taxes, per the Democrats' position, or in lower spending, per the Republican platform.  Our bet is that the cliff gets resolved in favor of neither.  Responsibility will give way to practicality.  Politicians despise austerity: even if they know it to be prudent, no one has ever been reelected on it.

The problem is, Nancy, you simply can't have it both ways.

The Fiscal Cliff

Ben Bernanke's ominous metaphor of a fiscal cliff to describe the pending economic contraction brought on by expiring tax cuts and mandated spending cuts has now embedded itself in the lexicon.  We've heard the beltway buzz surrounding the fiscal cliff described as "cliff diving", we've heard the cliff characterized as "more of a fiscal slope" and by one Citigroup equity strategist even as a "bungee jump".  Leave it to the ingenuity of Americans to turn a phrase.

The concern, however, is that many Americans are confusing the issues that may impact the economy in the very near term, with prudent fiscal policy in the longer term.  The markets, for their part, are largely discounting the whole affair, believing that at the 11th hour the politicians will "compromise" and, therefore, avoid the cliff.

But let's take stock as to what is on the table and what it means to compromise.  At year end, absent any political tinkering, roughly $600 billion of fiscal tightening is scheduled to trigger in the federal budget.  Approximately $100 billion of this total will come from sequestration of expenditures and the balance from the expiration of the Bush era tax cuts, the payroll tax, estate, AMT and capital gains taxes. In a word: austerity.  This is the do-nothing scenario, the dreaded fiscal cliff.

With politicians being as they are, however, the do-nothing scenario is largely discredited to the muddle-along.  Each party has drawn lines in the sand, and then another and another.  The question is what does it really mean to compromise.  The "grand bargain" as it's been discussed (there's that turning of the phrase, again) would involve the Republicans conceding to tax increases on the wealthy and Democrats agreeing to some level of spending cuts.  Should this come about, both measures will place fiscal drag on the economy, just less than the do-nothing scenario, rendering the cliff into something more of a fiscal slope.

And this is precisely our dilemma.  We all recognize that the government cannot go on endlessly racking up $1 trillion plus annual deficits, yet any measures to narrow the deficit or impose austerity, contribute to the cliff.  In the do-nothing scenario, the annual budget deficit would be cut in half in one year, but the fiscal drag on the economy would amount to as much as 4% of GDP.  This takes us then to the very nub of the problem: with the current level of federal deficit spending amounting to 8% of GDP any effort to rein in the deficit, poses a significant drag on the economy.  In essence, our economy is on life support and we are between a rock and a hard place.

Now, what's most curious about this is the Obama position.  Immediately following the election he came out swinging:  any proposals to resolve the fiscal cliff must involve higher taxes on the wealthy.  Ok, we get it.  He's Robin Hood and we're all living in the Sherwood Forest.  While this approach might hold populist appeal, it's curious in terms of its economic impact.

The CBO estimates that allowing the Bush era tax cuts to expire on the wealthy would raise approximately $42 billion per year - or roughly 4% of the budget deficit.  Four percent.  So, Obama is willing to endure $42 billion of fiscal drag because he's now preoccupied with fiscal prudence? And if it's an insignificant level of drag, at 4% of the deficit isn't it also an insignificant amount of budget savings?

It hardly sounds reasonable.  Rather, it seems Obama is searching for a grand political statement cloaked as a grand bargain.  He is saying that America is unfair.  Income disparity is unfair.  The tax system is unfair. The rich are unfair.  Capitalism is unfair.  It's all just so stinking unfair.  And we have to do something about it.  Little, but something.  Perhaps insignificant in the scheme of things, with little hope of tackling America's real economic issues, but something.