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Circling the Cliff

Article by David Malpass February 1, 2013 //   6 minute read
President Obama won a solid victory with 50% of the popular vote to 48% for Governor Romney. Obama did better than Romney with women, minorities, and young voters, and notched notable gains among Hispanic voters. Democrats added two seats to their 53-47 seat control of the Senate, losing a seat in Nebraska but picking up seats in Indiana, Massachusetts, and Maine. They also reduced the Republican majority in the House (currently 241-194) by roughly 5-10 seats. California voted to increase income tax rates on upper incomes and the sales tax rate to maintain education spending under Proposition 30. Once the election dust settles, a key variable in the direction of the economy and financial markets will be the tone of President Obama’s rhetoric and actions regarding growth policies and taxes. Both parties will want to appear open to bipartisan discussions on the fiscal cliff, but the scheduled tax increase is a big problem that won’t go away. The President’s choice for the new Treasury Secretary will be an important marker for taxes, spending, and the debt limit increase. We maintain our recession outlook for 2013 based on weak U.S. business investment, higher U.S. taxes, Europe’s deterioration, and the fiscal and regulatory crisis facing the federal and state governments. The current Fed policy is also contractionary because it channels regulated credit to the government, Fannie Mae, and Freddie Mac, and away from private-sector job creators. While U.S. housing is in recovery and China may make stimulative moves on monetary and credit policy, these positives won’t be enough to offset the drag. Key factors that may weigh on equity markets include: the size of the likely year-end tax increase even in the event of a partial deal; the political difficulty dealing with the fiscal issues (harder than in 2010); Europe’s deepening recession; and weak U.S. growth including recent data on autos, job openings, and bank lending (which has shrunk over the last 13 weeks). Regarding the year-end tax increase, a compromise will be harder to reach than in 2010 because:
  • The House majority, which is now Republican, was Democratic in 2010; in addition, members are more polarized.
  • The national debt is much bigger, making it harder to reach a kick-the-can fiscal deal as in December 2010 (basically both sides got all the tax cuts they wanted then without worrying about the deficit impact or the details of the legislation).
  • Extending current rates is more costly under Washington’s scoring rules than in 2010 because the baseline assumes even more tax increases than in December 2010.
  • The President and Republicans have just campaigned hard on distinctly different views of tax rates, making it hard to compromise on the year-end rate hike. The president wants an increase in tax rates for higher-income taxpayers. Meanwhile, the Republicans believe a tax-rate increase would hurt small businesses and jobs and are pledged to opposing tax increases, including limitations on tax deductions and credits unless they are matched with lower tax rates.
As a result, many tax rates are likely to go up at year-end, with most of the increases becoming permanent. Even if there is a partial lame-duck deal that temporarily extends some of the current rates, the problem for new business investment is that the tax code is likely to stay in chaos, perhaps for years. The procedural obstacles to reversing January 1 increases are huge as are the obstacles to tax reform. If he’s not able to work with House Republicans, President Obama will have several techniques to make policy:
  • The Administration can work to push treaties through the Senate during the lame duck session and in 2013 (treaties bypass the House.)
  • There’s likely to be a further expansion of the global governance processes through the United Nations, G20, and IMF (which is off budget). Undoing the sequester (something both parties want) may give the president an opportunity to increase other high-priority spending.
  • Similarly, the emergency supplemental spending needed for disaster relief for Hurricane Sandy will give opportunities to expand spending and government programs across a broad range.
  • The debt limit increase gives the president leverage because of the way the law is written — he can use it to shut down parts of the government and blame the other party. The August 2011 debt-limit increase shifted fiscal responsibility from the President to the Congress through the Super Committee. I’ve advocated rewriting the debt limit so it forces spending cuts .
  • Many regulations for Obamacare and Dodd-Frank are still being promulgated. Because the laws were written loosely, there is an unusually large policy impact from the wording of the regulations.
  • The new Consumer Finance Protection Bureau inside the Fed has immense power because it operates outside the appropriations process and has unlimited funding. One of its most ambitious proponents, Elizabeth Warren, won a Senate seat in Massachusetts.
  • The President may have the opportunity to make one or more Supreme Court appointments. He will also make numerous appointments to lower federal courts with the advice and consent of the Senate.
We expect growth to remain weak under current policies. Legislation during the lame duck is unlikely to fix the long-term uncertainty in the tax code. Equally troublesome, the legal restraints on federal spending and regulatory authority aren’t strong enough to restrain the government’s rapid expansion. This dampens business investment and points to continued weak growth.