Fiscal Cliff or Slippery Slope?
David R. Kotok
Cumberland Advisors, November 19, 2012

 

 

When it comes to US fiscal policy, are we faced with a cliff, or a slippery slope?  There is a difference between off-the-cliff Greece, the slippery-sloped European periphery, and the not-there-yet US.

We shall see if Alexis de Tocqueville may be right in his quote, “A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury.”

George Santayana was certainly right in his quote, “Those who cannot remember their past are condemned to repeat it.”

Fiscal cliffs are not unique to the US. However, there is a big difference between the European confrontation and the US confrontation. In Europe, the political forces have to deal with the results of failing to address budget gaps. They now confront debt in excess.  In many of those countries the debt-to-GDP ratio exceeds 100%.  Italy is the worst case among large economies; it is the third largest debtor in the world.

In Europe government budgets continue to swell. In France, the Economist reports, government has swelled to 57% of GDP.  This kills investment.  The CAC Index hasn’t had a new addition in a very long time.  The top income tax rate of 75% is driving wealth out of the country.

I will stop about Europe, since their rolling disaster is so well-known.

In the US, the Congress and the President are trying to negotiate a deal to avoid a European-style outcome. Our debt-to-GDP ratio is low enough (about 70% in publicly held debt) and our economy is strong enough (slow growth is not the same as shrinking) to permit that from happening. But to avoid disaster will require prompt, no-nonsense action.

In the US, it is possible to deal with our deficit problem prospectively. We have already done that once with the entitlement system, by recalculating Social Security payments over a longer time span and extending the retirement age.  We have the capacity to do it again with regard to post-retirement benefits and with additional changes in long-term entitlements. We also have demographics that have not deteriorated to the extent of Europe’s or Japan’s. If we wait long enough, however, we will descend to the same state of no return.

If we are smart enough to change our immigration laws and permit younger, entrepreneurial, enthusiastic people to enter our country legally, we will change our demographics for the better. The demographics would then favor robust growth for an extended period and provide adequate funding for our future entitlements and post-retirement benefits.  Is the US Congress smart enough to make that change?  I wonder – the indications are uncertain at best. We still elect too many idiots to the national legislative body.

By the way, those who accuse me of being either a Democrat or a Republican, depending on what I write, are quite wrong. I am neither. I believe both our political parties remain corrupted by money and ambitious politicians who are driven by short-term, election-driven agendas. Until our country is so disgusted with both of these parties that it is ready to demand material change, we will continue to get the shoddy government we asked for.

Let us get back to the difference between the US and Europe. European peripheral countries waited too long.  Now they cannot fund the promises that they made for retirement and post-retirement benefits, and so they have to impose austerity budgets. Those budgets strip away promises that were made. That is what drives people into the streets and increasingly threatens the political regimes of Europe.

European political leaders realize they have run out of rope. Especially in Greece, where the turmoil has been greatest, governmental leaders realize they must either severely alter the form of their government through austerity measures or see their society collapse into anarchy and chaos.

When governments impose austerity, they need police power to maintain civil order. In some sections of European cities, the police presence has been withdrawn or reduced and there is turmoil and deterioration of safety for the citizens. Other European countries are experiencing a migration of wealth. Citizens are not dumb; they vote with their feet if they are able to do it.

In the US, we see increasing divisions among the states. States that impose increasing levels of taxation continue to lose wealth to states that invite wealth and entrepreneurial spirit.  A good case in point is California, which has now imposed a higher level of taxation in order to preserve the payment streams from its pension system.  That system is bankrupting California cities, due to the overly generous pension policies they have put in place.

Here’s an example reported by Reuters:

“In bankrupt San Bernardino, a third of the city’s 210,000 people live below the poverty line, making it the poorest city of its size in California. But a police lieutenant can retire in his 50s and take home $230,000 in one-time payouts on his last day, before settling in with a guaranteed $128,000-a-year pension. Forty-six retired city employees receive over $100,000 a year in pensions.  Almost 75 percent of the city’s general fund is now spent solely on the police and fire departments, according to Reuter’s analysis of city bankruptcy documents – most of that on wages and pension costs.”

-Hat tip to my colleague, Michael Comes, for sending me the report.

Until California changes its behavior, it will lose wealth and income to other states.  We see this in comparisons among states around the country.

Now the US federal system is in the throes of a great debate as to whether it can remain a functional democracy and act prospectively.  Will it do so, rather than being forced to act retrospectively?  Consider this:  Barron’s reports that New Jersey’s median income for a household of four people (two kids) is $102,000.  That household will see a $6900 tax increase if we fall over the fiscal cliff and stay there.  Mississippi’s median income for the same-sized household is $58,000.  That household will get a $3100 tax hike.  I think you get my point about the cliff.

With regard to market impact of the fiscal cliff, one of the best summaries we’ve seen is from Strategas. We excerpt:

“Negative economic growth is typically associated with a drop in the S&P 500 of -30%.  Perhaps the Fed can help cushion this blow, and perhaps a “QE4” could boost the market +10% (QE1 saw the market rise +80%, QE2 was +33%, Operation Twist & LTRO were +29%, and QE3 was +15%, i.e., diminishing returns).  So, even if QE4 helps mitigate, say, +10% points of the -30% equity decline, that’s still a -20% decline, based on history.  It would be much better for fiscal policy makers to simply remove the cliff.”  Source: Strategas Weekly Economics Summary, November 18, 2012.

Let me repeat their final sentence for the congressional members who read this and for their staff.

It would be much better for fiscal policy makers to simply remove the cliff.”

We think the Obama, Reid, McConnell, Boehner, and Pelosi nexus may have begun to understand this. The election is over. We shall soon see whether we have adults in Washington.  Both sides now lose if they do not reach an agreement.  My colleague Bob Eisenbeis and I discussed this on Bloomberg TV on Friday.  See www.Bloomberg.com for the clip or go to www.cumber.com .

We wish readers a Happy Thanksgiving. This is a uniquely American celebration. Perhaps its traditions can inspire our politicians to seek compromise for the good of the nation.

 

~~~

David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors

Category: Markets, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

13 Responses to “Fiscal Cliff or Slippery Slope?”

  1. AHodge says:

    Completely agree David
    as far as calling economies a cliff–

    For US it is more like a big pothole
    even if they do nothing, US
    “only” has a mild to moderate recession
    and some fiscal improvement
    and odds of even this are well under even
    it is something “easily” avoidable–not that i take even a mild unnecessary recession lightly

    Europe in some sense has already stepped off the edge
    dithering so long while their credit supply and lending is completely broke.
    will look like one giant splat at the bottom of their cliff
    when we sadly look at this a year from now.
    Southern europe is already in the start of a depression
    the young are fleeing in droves abroad, 25% unemployment rates in a couple countries, and rapidly accelerating

    the work they do on sovereign bailout will barely begin to lessen the huge unrealized bank losses of $ 2 trillion
    which is mostly not sovereign it legacy stuff fromn 2008 and on and on
    the talk of reassuring markets with MORE budget austerity will look insane in a year

    Now thats a cliff! Their hair is on fire.

  2. Iamthe50percent says:

    My personal debt to GDP ratio is about 2.0, $144K debt, $57K income. I don’t see any problem with that. Payments are 20% of income. No problem. What’s magic about 1.0? The important thing is this, “Does it hurt to make the payments?” If the answer is, “No”, there is no problem. It is even more true if you own a printing press.

  3. WestFC043 says:

    What is the economic model behind this pro-austerity argument (which appears to come straight from the Bowles/Simpson playbook)? What evidence is there that it is the correct model — particularly when aggregate demand in the U.S. is sluggish, interest rates in the U.S. are at historical lows, and Europe’s ongoing experiment with austerity, both within and without the eurozone, shows increasingly less prospect of succeeding?

  4. rd says:

    These negotiations are going to be very tough.

    Both the Republicans and Democrats have to figure out how to raise taxes on the wealthy without actually raising taxes on their donors while geting most of the actual money from the people making less than $250k (actual money is different from press conference money). This is going to take at least a month of number crunching to figure out the details of the 3,000 page bill that will accomplish this. I expect this bill will also become home for numerous critical national defence procurement items like funding for a Cabbage Patch Doll Museum in some city that just happens to be in a major committee member’s district.

  5. Bob is still unemployed   says:

    > Fiscal Cliff or Slippery Slope?

    How can anyone have the minimum level of expectation for this problem being solved when no one, it appears, can even agree on how to characterize the problem?

  6. franklin411 says:

    Kotok may claim that he’s neither a Dem nor a Republican. But if you google his political contributions, you’ll see that he has given thousands of dollars in the last election cycle exclusively to Republicans.

    IMO, call yourself whatever you want, but own what you are.

  7. RW says:

    Poor Alexis de Tocqueville, even David Kotok abuses his memory with a misattributed quote.

    To the best its murky history can be determined, the statement “A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury” makes its first appearance on December 9, 1951, in an article in The Daily Oklahoman titled “This is the Hard Core of Freedom” by Elmer T. Peterson.

    The author of that article, Peterson, appears to be quoting Alexander Fraser Tytler but even this is not entirely certain because their is no citation. About the only certainty we do have is that he was not quoting Tocqueville who never would have said such a thing.

  8. MojaveMax says:

    I see lots of talk about undoing the “fiscal cliff” legislation, but almost nothing about the potential response from the ratings agencies should the USA fail to address its debt and deficits.

  9. Greg0658 says:

    I like ya seemingly enough** but this got me turned off ..
    ‘If we are smart enough to change our immigration laws and permit younger, entrepreneurial, enthusiastic people to enter our country legally, we will change our demographics for the better. The demographics would then favor robust growth …..’
    (hense)
    we have this idle cement kiln just blocks behind me – maybe our lowIQs can see it – after me* .. actually its the midIQs isn’t it (more of them) – the lowIQs are a “Save the __” workgroup somewhere – just wait 15 minutes – one of them will pop up on your TV screen

    * I ask again – if I perish without a legal pass of pension benefits to anyone else – is that positive for the “Precious” Market – blip – evapotated #s in an account ??
    no juice for you local econ – earn it again kiddo2 – a # crunch TAKE as an income statement for “PreciousM”

    ** I know your just playing the game – I know I know

  10. 873450 says:

    “A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury.”

    De Tocqueville can’t foresee elected government constructing almost overnight and maintaining without public support the mother of all socialist, safety net entitlements to unconditionally rescue, protect and reward a corrupted TBTF banking system primarily benefiting 1%.

    When money trumps majority there is no democracy.

    “I believe both our political parties remain corrupted by money and ambitious politicians who are driven by short-term, election-driven agendas. Until our country is so disgusted with both of these parties that it is ready to demand material change, we will continue to get the shoddy government we asked for.”

    This 2-party system producing shoddy government is more force fed than asked for. Take corrupting money out of elections and ambitious politicians will be driven by a different agenda – administering government of, by and for the people. If we are truly exceptional, the majority will best know and decide how to guard and spend “their” treasure.

  11. 873450 says:

    RW Says:
    “Poor Alexis de Tocqueville … misattributed quote … Elmer T. Peterson … Alexander Fraser Tytler … About the only certainty we do have is that he was not quoting Tocqueville who never would have said such a thing.”

    No matter. The notion every democracy – majority elected government – shares the same destiny ending in irresponsible bankruptcy like modern Greece is always wrong.

  12. [...] buy it. First off, I detest single variable analysis when it comes to market action. And second, as David Kotok explained, the fiscal cliff is more of a slippery slope than an actual abrupt [...]

  13. RW says:

    @873450, agreed.

    Irresponsible bankruptcy may be an inevitable outcome for aristocracy and oligarchy because of the way these systems constrain mobility, opportunity and social justice but that destiny would be unlikely for a democracy. Even poor Greece may pull out in the long run if it can figure out a way to make the wealthy pay their taxes.