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Cliff Notes

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On May 22, the Congressional Budget Office released its report on how the United States can avoid going off the “fiscal cliff” on January 1, 2013.  The report is entitled, “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013”.  Forget about the Mayan calendar and December 21, 2012.  The real disaster is scheduled for eleven days later.  The CBO provided a brief summary of the 10-page report – what you might call the Cliff Notes version.  Here are some highlights:

In fact, under current law, increases in taxes and, to a lesser extent, reductions in spending will reduce the federal budget deficit dramatically between 2012 and 2013 – a development that some observers have referred to as a “fiscal cliff” – and will dampen economic growth in the short term.

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Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects – with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half.  Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.

As the complete version of the report explained, the consequences of abruptly-imposed, draconian austerity measures while the economy is in a state of anemic growth in the wake of the 2008 financial crisis, could have a devastating impact because incomes will drop, shrinking the tax base and available revenue – the life blood of the United States government:

The weakening of the economy that will result from that fiscal restraint will lower taxable incomes and, therefore, revenues, and it will increase spending in some categories – for unemployment insurance, for instance.

An interesting analysis of the CBO report was provided by Robert Oak of the Economic Populist website.  He began with a description of the cliff itself:

What the CBO is referring to is the fiscal cliff.  Remember when the budget crisis happened, resulting in the United States losing it’s AAA credit rating?  Then, Congress and this administration just punted, didn’t compromise, or better yet, base recommendations on actual economic theory, and allowed automatic spending cuts of $1.2 trillion across the board, to take place instead.  These budget cuts will be dramatic and happen in 2012 and 2013.

Spending cuts, especially sudden ones, actually weaken economic growth.  This is why austerity has caused a disaster in Europe.  Draconian cuts have pushed their economies into not just recessions, but depressions.

The conclusion reached by Robert Oak was particularly insightful:

This report should infuriate Republicans, who earlier wanted to silence the CBO because they were telling the GOP their policies would hurt the economy in so many words.  But maybe not.  Unfortunately the CBO is not breaking down tax cuts, when there is ample evidence tax cuts for rich individuals do nothing for economic growth.  Bottom line though, the CBO is right on in their forecast, draconian government spending cuts will cause an anemic economy to contract.

Although the CBO did offer a good solution for avoiding a drive off the fiscal cliff, it remains difficult to imagine how our dysfunctional government could ever implement these measures:

Or, if policymakers wanted to minimize the short-run costs of narrowing the deficit very quickly while also minimizing the longer-run costs of allowing large deficits to persist, they could enact a combination of policies:  changes in taxes and spending that would widen the deficit in 2013 relative to what would occur under current law but that would reduce deficits later in the decade relative to what would occur if current policies were extended for a prolonged period.

The foregoing passage was obviously part of what Robert Oak had in mind when he mentioned that the CBO report would “infuriate Republicans”.  Any plans to “widen the deficit” would be subject to the same righteous indignation as an abortion festival or a national holiday for gay weddings.  Nevertheless, Mitt Romney accidentally acknowledged the validity of the logic underlying the CBO’s concern.  Bill Black had some fun with Romney’s admission by writing a fantastic essay on the subject:

Romney has periodic breakdowns when asked questions about the economy because he sometimes forgets the need to lie.  He forgets that he is supposed to treat austerity as the epitome of economic wisdom.  When he responds quickly to questions about austerity he slips into default mode and speaks the truth – adopting austerity during the recovery from a Great Recession would (as in Europe) throw the nation back into recession or depression.  The latest example is his May 23, 2012 interview with Mark Halperin in Time magazine.

Halperin: Why not in the first year, if you’re elected — why not in 2013, go all the way and propose the kind of budget with spending restraints, that you’d like to see after four years in office?  Why not do it more quickly?

Romney: Well because, if you take a trillion dollars for instance, out of the first year of the federal budget, that would shrink GDP over 5%.  That is by definition throwing us into recession or depression.  So I’m not going to do that, of course.”

Romney explains that austerity, during the recovery from a Great Recession, would cause catastrophic damage to our nation.  The problem, of course, is that the Republican congressional leadership is committed to imposing austerity on the nation and Speaker Boehner has just threatened that Republicans will block the renewal of the debt ceiling in order to extort Democrats to agree to austerity – severe cuts to social programs.  Romney knows this could “throw us into recession or depression” and says he would never follow such a policy.

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Later in the interview, Romney claims that federal budgetary deficits are “immoral.”  But he has just explained that using austerity for the purported purpose of ending a deficit would cause a recession or depression.  A recession or depression would make the deficit far larger.  That means that Romney should be denouncing austerity as “immoral” (as well as suicidal) because it will not simply increase the deficit (which he claims to find “immoral” because of its impact on children) but also dramatically increase unemployment, poverty, child poverty and hunger, and harm their education by causing more teachers to lose their jobs and more school programs to be cut.

Mitt Romney is beginning to sound as though he has his own inner Biden, who spontaneously speaks out in an unrestrained manner, sending party officials into “damage control” mode.

This could turn out to be an interesting Presidential campaign, after all.



 

When the Music Stops

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Forget about all that talk concerning the Mayan calendar and December 21, 2012.  The date you should be worried about is January 1, 2013.  I’ve been reading so much about it that I decided to try a Google search using “January 1, 2013” to see what results would appear.  Sure enough – the fifth item on the list was an article from Peter Coy at Bloomberg BusinessWeek entitled, “The End Is Coming:  January 1, 2013”.  The theme of that piece is best summarized in the following passage:

With the attention of the political class fixated on the presidential campaign, Washington is in danger of getting caught in a suffocating fiscal bind.  If Congress does nothing between now and January to change the course of policy, a combination of mandatory spending reductions and expiring tax cuts will kick in – depriving the economy of oxygen and imperiling a recovery likely to remain fragile through the end of 2012.  Congress could inadvertently send the U.S. economy hurtling over what Federal Reserve Chairman Ben Bernanke recently called a “massive fiscal cliff of large spending cuts and tax increases.”

Peter Coy’s take on this impending crisis seemed a bit optimistic to me.  My perspective on the New Year’s Meltdown had been previously shaped by a great essay from the folks at Comstock Partners.  The Comstock explanation was particularly convincing because it focused on the effects of the Federal Reserve’s quantitative easing programs, emphasizing what many commentators describe as the Fed’s “Third Mandate”:  keeping the stock market inflated.  Beyond that, Comstock pointed out the absurdity of that cherished belief held by the magical-thinking, rose-colored glasses crowd:  the Fed is about to introduce another round of quantitative easing (QE 3).  Here is Comstock’s dose of common sense:

A growing number of indicators suggest that the market is running out of steam.  Equities have been in a temporary sweet spot where investors have been factoring in a self-sustaining U.S. economic recovery while also anticipating the imminent institution of QE3.  This is a contradiction.  If the economy were indeed as strong as they say, we wouldn’t need QE3.  The fact that market observers eagerly look forward toward the possibility of QE3 is itself an indication that the economy is weaker than they think.  We can have one or the other, but we can’t have both.

After two rounds of quantitative easing – followed by “operation twist” – the smart people are warning the rest of us about what is likely to happen when the music finally stops.  Here is Comstock’s admonition:

The economy is also facing the so-called “fiscal cliff” beginning on January 1, 2013.  This includes expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester.  Various estimates placed the hit to GDP as being anywhere between 2% and 3.5%, a number that would probably throw the economy into recession, if it isn’t already in one before then.  At about that time we will also be hitting the debt limit once again.   U.S. economic growth will also be hampered by recession in Europe and decreasing growth and a possible hard landing in China.

Technically, all of the good news seems to have been discounted by the market rally of the last three years and the last few months.  The market is heavily overbought, sentiment is extremely high, daily new highs are falling and volume is both low and declining.  In our view the odds of a significant decline are high.

Charles Biderman is the founder and Chief Executive Officer of TrimTabs Investment Research.  He was recently interviewed by Chris Martenson.  Biderman’s primary theme concerned the Federal Reserve’s “rigging” of the stock market through its quantitative easing programs, which have steered so much money into stocks that stock prices have now become a “function of liquidity” rather than fundamental value.  Biderman estimated that the Fed’s liquidity pump has fed the stock market “$1.8 billion per day since August”.  He does not believe this story will have a happy ending:

In January of ’10, I went on CNBC and on Bloomberg and said that there is no money coming into stocks, and yet the stock market keeps going up.  The law of supply and demand still exists and for stock prices to go up, there has to be more money buying those shares.  There is no other way in aggregate that that could happen.

So I said it has to be coming from the government.  And everybody thought I was a lunatic, conspiracy theorist, whatever.  And then lo and behold, on October of 2011, Mr. Bernanke then says officially, that the purpose of QE1 and QE2 is to raise asset prices.  And if I remember correctly, equities are an asset, and bonds are an asset.

So asset prices have gone up as the Fed has been manipulating the market. At the same time as the economy is not growing (or not growing very fast).

*   *   *

At some point, the world is going to recognize the Emperor is naked. The only question is when.

Will it be this year?  I do not think it will be before the election, I think there is too much vested interest in keeping things rosy and positive.

One of my favorite economists is John Hussman of the Hussman Funds.  In his most recent Weekly Market Comment, Dr. Hussman warned us that the “music” must eventually stop:

What remains then is a fairly simple assertion:  the primary way to boost corporate profits to abnormally high – but unsustainable – levels is for the government and the household sector to both spend beyond their means at the same time.

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The conclusion is straightforward.  The hope for continued high profit margins really comes down to the hope that government and the household sector will both continue along unsustainable spending trajectories indefinitely.  Conversely, any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins.  With the ratio of corporate profits to GDP now about 70% above the historical norm, driven by a federal deficit in excess of 8% of GDP and a deeply depressed household saving rate, we view Wall Street’s embedded assumption of a permanently high plateau in profit margins as myopic.

Will January 1, 2013 be the day when the world realizes that “the Emperor is naked”?  Will the American economy fall off the “massive fiscal cliff of large spending cuts and tax increases” eleven days after the end of the Mayan calendar?  When we wake-up with our annual New Year’s Hangover on January 1 – will we all regret not having followed the example set by those Doomsday Preppers on the National Geographic Channel?

Get your “bug-out bag” ready!  You still have nine months!


 

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