How Will The Fiscal Cliff Get Resolved?

"I am quite concerned about Fiscal Cliff." - Alan Greenspan

"I am a firm believer in the people.  If given the truth, they can be depended upon to meet any national crisis.  The great point is to bring them the real facts." - Abraham Lincoln

"Any idiot can face a crisis - it's day to day living that wears you out." - Anton Chekhov

Alan Greenspan the former Chairman of the Federal Reserve is not my favorite person.  Now I cannot blame him for everything because that would be unfair, but I do believe that his loose monetary policies started the drive towards a fiscal cliff by allowing politicians to behave irrationally and spend money in a flagrant way.  Once he had started the ball rolling Bernanke picked it up and has run with it better than Hussein Bolt breaking the world 100 meter dash.  So it is ironic to me that the ex-Chairman has finally decided that the Federal Reserve is not all powerful and that unless the politicians get their act together that the looming Fiscal Cliff will create an economic problem.

By once again voting to postpone the inevitable day of reckoning our politicians have driven us once again to the edge of a Fiscal Cliff so the questions are how will it get resolved and if it does not what does that mean?  Let's start with the second question first.  The Fiscal Cliff was created in the third quarter of 2011 when congress was at an impasse regarding raising the debt ceiling.  In order to push through the increase in the debt ceiling (they had to as the level of the debt had reached the maximum allowed) they agreed to severe tax increases and spending cuts in an effort to curb the spiralling budget deficit.  In true political fashion they kicked the can to the end of Obama's first term and so these all kick in at the end of this year.

According to economic consensus if all of the tax increases and spending cuts go through it will shave roughly 4% off GDP growth.  Some have it pegged at slightly less than that while others have it as high as 7%, but either way, as the economy is only growing at under 2% a year at present, shaving 4% off that pushes the United States into a recession instantly.  So now that we know what the Fiscal Cliff means what is going to be accomplished between now, the Presidential election and the end of the year?

Politicians are by nature very slippery.  It is a shame that we could not get the truth out of them, but that seems like an impossibility especially around election time.  On the surface it appears that there are some cuts and tax increases that will be allowed to happen regardless of who is elected.  Both candidates have said that the tax on the wealthy will happen and both have said that they want to try to protect the middle class, so if you strip out the tax increases that are pointed at the middle class you have taken out just under half of all the tax increases.  The remainder will more than likely go through and this will create a minimum of a 2% drag on economic growth.

So what are the other pieces that will go through?  On the tax side there is $79B to the wealthy, $140B increase in Social Security (this will hit small business hardest) and extended unemployment benefits for a total of $219B.  On the spending side there is the Budget Control Act of $160B mostly targeted at defense spending for a grand total of $379B.  If these are left to kick in that drag on the economy would knock a minimum of 2% off GDP and would effectively wipe out any growth in 2013.  I would say that this is almost a sure thing regardless of who wins the election as if the Republicans lose, they will want to ensure that Obama does not spend in his second term and if Romney wins he will want to prove himself tough and will take the hard choices up front in an effort to give himself time to recover later in his term.

Combine this with weak earnings from businesses, a weak global economy and you have the very real potential that this 2% drag will be enough to push the United States into a recession in 2013.  I still believe that it will be relatively mild in terms of GDP contraction, but I also believe that the stock market is priced for perfection and that a recession, no matter how mild will have a tremendous impact on the market.