The Exchange

3 Reasons to Fade a Fiscal Cliff Freak-out

The Exchange

Is Wall Street freaking out about the "fiscal cliff"?

It has appeared that way at times in the week since President Barack Obama's re-election cast urgent attention on the need for a budget compromise before $600 billion in automatic tax increases and spending cuts kicks in.

Here's a handy way to determine what might cause financial markets to overreact to an approaching event: Figure out what economic surprise last made a number of smart people feel stupid for having underestimated its potential for market mayhem

The last episode that humbled many astute economists and investors was the tenacious standoff in Congress in the summer of 2011 over raising the nation's borrowing limit. Debt-ceiling votes were widely viewed as procedural necessities, and the notion of inviting a potential government default was unthinkable to rational analysts, leading them to assume cooler heads would prevail.

Of course, the mutual stubbornness of the party leaders sparked a credit-agency downgrade of the United States, and a market tantrum dropped the Dow 2,000 points in three months, blindsiding the Washington and Wall Street consensus.

As a result, perhaps, too much of the foreboding discussion of the fiscal cliff treats it as a daunting either-or suspense movie, the markets alternately seeing it as a light at the end of the tunnel or the oncoming train.

Separating the amorphous threat into its essential elements, though, gives a clearer view of whether market panic makes sense. There are three issues to focus on:

-Recession risk: It's being taken as a given in too many places that the $50 billion or so in monthly effects of the full fiscal contraction would trigger a recession. The rampantly repeated Congressional Budget Office estimates are for a 3% reduction in economic output if the maximum effects were in place for all of 2013. This is an exceedingly unlikely outcome, given the elements of agreement about extending or finding ways around many of the expiring provisions.

Michael Darda, chief market strategist at MKM Partners, points out that no U.S. recession in the past 100 years has occurred without the Federal Reserve constricting the money supply by either higher interest rates or other means. Tighter money is certainly not an element of today's economy and won't likely be anytime soon, even though rates are already near zero.

There is also evidence that businesses have already been anticipating a potential slowdown due to nonproductive talks in Washington, and have curtailed spending on plant and equipment. This would mean some of the pain has been front-loaded, and if a palatable budget compromise is forged, it will uncork pent-up demand early next year. J.P. Morgan Chase & Co. (JPM) Chief Executive Jamie Dimon hinted at this prospect last week when he suggested "the economy can boom" if the fiscal issues are sufficiently addressed.

Like a steep rise in gasoline prices, the bump in payroll and income taxes would pressure spending across the economy and reduce its cushion against another descent into recession, but by no means would it guarantee one.

IHS (IHS) economist Nigel Gault this week issued a "worst-case scenario" for the economy, amounting to a 1.7% decline in U.S. output in 2013 — but this is based on not only the full fiscal-cliff impact but also a breakup of the euro zone, an oil spike from renewed Middle East hostilities and a significant slowdown in China. If all that happens in the coming months, panic would certainly be warranted, but there's a reason it's called a "worst case."

-Fiscal abyss? When the public becomes consumed with typically arcane economic and federal budget matters, it often means the underlying crisis has peaked. The early '90s deficit anxiety that propelled Ross Perot to pulling 19% of the popular vote for president in 1992 climaxed even as the country was about to reap a huge disarmament "peace dividend" and the economy was gathering strength for a multi-year growth streak.

Similarly, the preoccupation in 2008 with a "peak oil" resource shortage that produced the campaign applause line of "Drill, baby, drill," came just as North American energy supplies were surging and oil prices in descent.

While the country has vastly more debt today, both in absolute terms and relative to the economy's size, the deficit as a proportion of the economy reached its maximum above 10% in 2009 and has been shrinking since. This points to the fact that the huge, immediate budget imbalance has a great deal to do with the severe depth of the 2008-'09 recession.

Furthermore, the U.S. government spends only slightly more in absolute dollars on interest on its debt annually than it did in the mid-1990s, thanks to rock-bottom borrowing rates, and debt service is a small sliver of total spending. This doesn't mean the $1 trillion budget gap will close on its own, but there is more time to arrive at a long-term structural budget improvement than is generally perceived.

-The tax-hike threat. When the debate is really only over whether taxes on high-earning Americans will rise less than four percentage points and capital-gains taxes five points, it's hard to take seriously that this is a decisive swing factor in either economic-growth incentives or investment returns.

The trench across which this war is being waged is so narrow that inevitably both sides systematically overstate the impact of the contemplated changes. Republicans are over-invested in suggesting that cinching up tax rates for high earners to 1990s levels would sap the impulse for small-business expansion. This amounts to claiming a small business owner who believes a new worker would generate a profit for the company would hire that person if the owner had 65% of the profit over $250,000 a year left over after federal taxes are deducted, but not if the after-tax take were 60.5%.

Likewise, Democrats are eager to point to boosting taxes on the wealthy as a significant help in closing the deficit, when in the short term it would make only a small dent in the budget gap. Longer-term, having higher rates on large incomes and investment gains could accelerate deficit reduction in a faster-growing economy, as it did in the '90s, but this is a secondary benefit.

Taxes also appear overplayed as a factor in investment decisions and market performance. Echoing several academic studies, O'Shaughnessy Asset Management ran through the history of increases in income, dividend and capital-gains taxes, and found no consistent relationship between tax-rate changes and subsequent stock market returns.

There's no denying the prospect of elected leaders acting capriciously offers plenty to worry about.  And perhaps an ultimate compromise will only come as a result of an anticipatory market freak-out. But based on reasonable assessments of the likely impact, there's at least a decent chance that a benign economic outcome is the thing that will make lots of experts and investors feel stupid in a few months.

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