Asset management

7 January 2013

Economist Insights Deal again
Last week’s US fiscal cliff agreement was just the first round of the fiscal cliff games. Everything that was agreed was about tax, and spending still remains to be addressed. The next few rounds will focus on the sequester, the debt ceiling and the continuing resolution. The uncertainty about the fiscal cliff had real effects on the economy, and the agreement reached over the New Year only removes some of the uncertainty. There is still more to be done. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

In the end, the US did go over the fiscal cliff but, given that the agreement the next day came on a public holiday, this was purely technical. The bungee cord bounced back almost immediately. For the coming year, Congress agreed to extend enough of the tax cuts to offset about two-thirds of the fiscal cliff. But this was just the first round of the fiscal cliff games. Spending decisions were pushed back a couple of months and the debt ceiling is looming larger. The agreements so far look to be enough to stabilise the US deficit at about 3% of GDP over the next decade (see chart 1), as compared to the 7% deficit that was posted in 2012. It is worth noting that even if all the tax breaks had been extended (the ‘full extension’ line) there would have been some tightening because of planned limits on discretionary spending but also because GDP growth gradually shrinks the relative size of the deficit. As such, the recent agreement has speeded up the path of tightening by about 1%. On its own this is not enough to bring down the US debt-GDP ratio, and crucially the deficit starts to widen again at the end of the forecast horizon. More needs to be done. After all, everything that was agreed was about tax and spending remains to be addressed (see chart 2). The fiscal cliff was just the first hand in the poker game that is the US fiscal process. There are at least three more hands to be played in the coming months. The first is the sequester, which is a set of automatic across-the-board spending cuts that were the price the Republicans demanded for increasing the debt ceiling back in summer of 2011. These were meant to start in January, but the Democrats bought a two month extension in return for agreeing to another USD 24 billion in spending cuts overall. The debate will be on how the spending cuts should be achieved (and even if they should go ahead). If no agreement is made then automatic across-theboard spending cuts kick in.

Chart 1. Warning: low ceiling US deficit projections as a share of GDP under different scenarios 0 -1 -2 -3 -4 -5 -6 -7 -8 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Full fiscal cliff Agreement Full extension Debt ceiling

Source: Congressional Budget Office, UBS Global Asset Management. The ‘Full fiscal cliff’ is the CBO’s August Baseline and the ‘Full extension’ is the CBO’s August alternative baseline.

Chart 2. Tax or spend? Cumulative fiscal tightening between 2012 and 2022 as a share of GDP under different scenarios 7 6 5 4 3 2 1 0 -1 -2 Full fiscal cliff Revenues Outlays Agreement Deficit Full extension

Source: Congressional Budget Office, UBS Global Asset Management

The second hand of fiscal poker is the big one – the debt ceiling. The Treasury hit the debt ceiling towards the end of December and is now engaged in various extraordinary measures to keep financing going for about another two months. If no agreement is made, the only options are to shut down parts of the government or default on their creditors. If no agreement is reached on the fiscal cliff this will be the equivalent of going from a 7% deficit down to a 0% deficit in the space of a few months (chart 2). Just ask the Greeks how much fun that kind of tightening has been. Even if there is a resolution to the fiscal cliff, the next hand to be played is the continuing resolution. Amazingly enough, the US federal government does not have an agreed budget. The government is continuing purely on a ‘continuing resolution’, which is basically an extension of the previous budget. There will need to be an agreement on a new budget or at least an extension of the continuing resolution before 27 March or the government will be forced to shut down. In the fiscal cliff round that was just played, the Democrats clearly had the stronger hand. Democrats wanted to see some taxes go up, while Republicans did not want to see any taxes go up. If no agreement had been reached everyone’s taxes would have gone up, and in the minds of the electorate it would have been the obstinacy of the Republicans that did it. It turns out that, in poker terms, the Republicans were bluffing and the Democrats called the bluff. Given their relative position, in retrospect the Democrats may come to regret that they were unable to secure more commitments on spending while they held all the cards. That lost opportunity may come to be sorely regretted. The next rounds are all about spending and now it is the Republicans who hold the stronger hand. The debt ceiling is really their Ace of Spades, so they may attempt to combine all of the coming issues into one round. The electorate may be more likely to accept the idea that it is the Democrats who are unwilling to sacrifice on spending, so the blame will be far less obvious. The Republicans can present themselves as reasonable for having made concessions on tax.

There is one wild card, however, which is the questionable constitutional status of the debt ceiling. On the one hand Congress has imposed a ceiling on borrowing, but on the other hand it has agreed tax and spending plans that will break that ceiling. In effect, it has ordered the Treasury to do two mutually contradictory things, and President Obama might choose to go to the Supreme Court on the basis that the 14th Amendment forbids any default on outstanding federal debt. This wild card could trump the Republicans’ Ace, but would just add more uncertainty to the whole debate. Additional uncertainty is the last thing that the economy and markets need. The uncertainty about the fiscal cliff had real effects on the economy – most particularly in business investment. The agreement reached over the New Year only removes some of the uncertainty, so there is little hope of any quick bounce-back in business investment. On a more positive note, however, for longer-term fiscal sustainability the US clearly needed higher revenue and spending cuts. If first the Republicans and then the Democrats lose their rounds, this may be exactly what the US gets.

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