Placing the US Fiscal Cliff into Context

Economic Implications of the Fiscal Cliff

Now that the Fed has invoked a third tranche of quantitative easing, financial markets have refocused their attention on the possible economic and financial implications of an unfolding US fiscal cliff scenario. Under current legislation, US fiscal policy will be tightened by 3% of GDP in 2013. Such a tightening would be unprecedented. The last significant tightening of US fiscal policy remotely similar was undertaken in 1969 when the US economy was displaying considerable signs of overheating. The Fed attempted to contain inflation by tightening monetary policy. The combination of tighter fiscal and monetary policies pushed the economy into recession in 1970. The big differences between the current environment and 1970 are easy to identify: the Fed will not be tightening policy anytime soon, because the US economy is not exhibiting any signs of overheating.

Fed Chairman Bernanke admits that a full fiscal cliff scenario would produce a recession. This would result in recalibrated expectations for corporate profits. Risky asset prices would fall. The invocation of the third tranche of quantitative easing was justified by elevated unemployment being assigned a higher degree of importance within the Fed’s dual mandate. It is also reasonable to assert that the third tranche embodies an element of partial insurance in case the fiscal cliff scenario unfolds. The Fed is unable to totally cushion the US economy from the recessionary effects of this outcome.

The Prospective Size of Fiscal Tightening

US political gridlock was always seen as being good for the economy and financial markets, because economic management would de facto be transferred to the Fed. This view has now become increasingly challenged: gridlock has become synonymous with brinkmanship, thereby producing a huge source of uncertainty to the private sector. The first casualty of this uncertainty under the current fiscal cliff backdrop has been notable weakness in US capital spending.

It is widely felt that some agreement will be reached after the 6 November elections whereby large fiscal tightening is avoided. The worst possible outcome for financial markets would be if fiscal tightening is simply deferred without credible long-term measures to reduce the deficit being invoked with immediate effect. Fed Chairman Bernanke recommends deferring the immediate fiscal tightening, but instituting credible measures aimed at producing long-term fiscal sustainability. The size of prospective fiscal tightening will ultimately be influenced by the election outcome, the most likely of which appears to be some continuation of the status quo.

Under a status quo scenario, there is a strong probability of dilution to the impending fiscal tightening. The key for the economy and financial markets would be whether the Fed could soften the impact through further monetary easing. A clean-sweep by the Republicans would produce significant fiscal tightening via cuts in government spending. The least chance of significant fiscal tightening in 2013 would come under a Democratic clean sweep.

The Domestic Impact of Fiscal Tightening

Given the high prospect of a continuation of the status quo, we should expect some fiscal tightening in 2013. The impact on the real economy will depend on the composition of tightening: lower government spending will have a direct measurable impact on aggregate demand, but there will also be consequences for the private sector. A reduction in federal government contracts to the private sector will produce a secondary impact on aggregate demand as the affected firms re-adjust hiring and capital spending intentions accordingly to the new tighter fiscal regime.

The most likely combination of the fiscal tightening is lower government spending and a rise in marginal tax rates. The latter could impact capital spending, since it would effectively raise the hurdle rate for undertaking investment in plant and equipment. This could adversely affect the supply-side of the economy.

Will the Fiscal Cliff Impact Dividend Policy and US Equity Prices?

Under current law, the tax rate on dividends will rise from 15% to 43.4% in 2013 at the highest tax bracket. The new tax rate would encompass a 3.8% Medicare surcharge on investment income. If the top tax rate on dividends reverts to 43.4%, then after-tax dividend yields on equities take a significant hit. This could seemingly reduce the attraction of receiving dividends. That having been said, future dividend policy will probably still be dictated by investors’ appetite and requirements for dividends. Under normal circumstances, investors would demand compensation for a decline in the after-tax dividend yield via lower stock prices. We are not, however, in a normal setting. Given current circumstances, we need to place dividend yields into context versus alternative financial instruments.

The Fed has made it perfectly clear that short-term interest rates will remain on hold until 2015. Meanwhile, US Treasuries are seemingly not offering rates of return that are sufficient to compete with dividends. Furthermore, the tax rate on interest income will also rise, from 35% to 38.8% in 2013. Given the thirst for yield in the current abnormal interest rate environment, the rise in tax rates on dividends may not result in investors’ totally shunning equities. The quest for yield has been testified by a shift in valuations between dividend-paying and non-paying stocks: the differential between the trailing P/E ratios on dividend-paying stocks (13.5) and non-paying stocks (15.6) has narrowed to 2.1, compared to a 20-year monthly median differential of 13.4.

Putting US Fiscal Consolidation into Global Context

Austerity has been fashionable in much of the developed world since 2010 due to high levels of government debt relative to GDP. Those commentators most vocal in making the case to avoid the fiscal cliff in the US often cite the post-2010 experience of Europe to make their case. The sheer size of fiscal austerity has, in some cases, placed countries into debt traps, where the ability of the afflicted country to grow has deteriorated and, therefore, increased fiscal unsustainability. For countries where nominal GDP growth is lower than the sovereign long-term cost of capital, the prospect of the so-called debt trap needs to be avoided at all costs by shifting emphasis towards growth.

US nominal GDP is currently running around +2.8% year-on-year. The yield on 10-year US Treasuries is 1.6%, implying that the US in not in a debt trap. By contrast, nominal GDP in the Eurozone is only up +0.8% year-on-year, but the average long-term government bond yield in the region is running at 2.4%. The eurozone is, therefore, seemingly caught in the dreaded debt trap. The gap between nominal GDP growth and long-term government interest rates would have been even larger if the European Central Bank (ECB) had not been more aggressive in its bond purchases under its current President.

Governments across the developed world face the same challenge in terms of achieving the correct balance of austerity: too many front-end loaded measures do not necessarily enhance long-term fiscal sustainability if that economy’s ability to engineer respectable growth is undermined. Austerity adversely impacts aggregate demand, which, in turn, reduces the size of the tax base as unemployment rises, thereby boosting borrowing requirements. This is the situation afflicting the eurozone and the United Kingdom. Meanwhile, the United States has, thus far, managed to avoid the aforementioned plight, but this status is seemingly threatened by the fiscal cliff.

2013 Global Growth Constrained by Fiscal Tightening and Higher Fiscal Multiplier

The International Monetary Fund (IMF) has just downgraded its forecasts for world economic growth for 2012 and 2013. Continued fiscal policy adjustment in the developed world is one of the reasons for the lower growth forecasts. The IMF considers a full-blown US fiscal cliff scenario as being “tail risk” event, but it concedes that the US would enter recession if fiscal policy was tightened by 3% of GDP. A US recession would impart significant knock-on effects to the rest of the global economy. The most obvious transmission mechanism would be through financial markets: recalibration of corporate profit expectations would adversely impact risky asset prices globally.

Another reason why the IMF has decided to downwardly revise its growth outlook is that its earlier forecasts may have underestimated the impact of fiscal adjustment on headline GDP growth. This would indicate that the fiscal multiplier was higher than previously estimated. It would imply that any given amount of fiscal consolidation is likely to have a bigger impact on GDP. The IMF believes that the value of the fiscal multiplier averaged 0.5 in the thirty year period prior to the Great Recession. Under this scenario, fiscal consolidation of 1% would have reduced real GDP growth by -0.5%. Since the Great Recession, however, the IMF believes the value of the fiscal multiplier in developed countries now ranges from 0.9 to 1.7. In other words, fiscal consolidation now has a much bigger impact on real GDP growth than previously estimated. This is why it is important for the US to avoid the full-blown fiscal cliff outcome.

Under normal conditions, aggressive easing of monetary policy could act as a potential offset to support aggregate demand. With interest rates now down at the virtual zero bound lower limit in advanced countries, this option is now less effective. This is why it is critical for advanced economies to strike the correct balance in the structure and duration of fiscal consolidation. Fed Chairman Bernanke is correct: avoid aggressive immediate fiscal tightening to support aggregate demand, but undertake credible long-term measures to address structural budget problems. Stay tuned!

Summary and Conclusions

Under current law, US fiscal policy will be tightened by 3% of GDP in 2013. This would be unprecedented and would produce a recession. Congressional action is required to enact legislation that would defer the immediate fiscal tightening.

The magnitude and structure of 2013 fiscal tightening will depend on the election outcome. Some continuation of the status quo is likely. The most likely outcome appears to be some increase in marginal tax rates and selected government spending cuts.

The US fiscal cliff includes a sharp increase in the tax rate on dividends. Under normal conditions, the appeal of dividends would suffer. The quest for yield in the current abnormal interest rate environment may not result in a collapse in investors’ appetite for dividend-paying stocks.

In contrast to Europe, the US has managed to escape the debt trap by not engaging in aggressive front-end loaded austerity. The onset of a full-blown fiscal cliff scenario would completely undermine the growth path of the US economy.

The IMF has revised down its forecasts for world economic growth in 2012 and 2013. Continued fiscal consolidation and higher estimates for the fiscal multiplier are partly behind the lower estimates for economic growth.

About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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