Citi on the coming fiscal crunch:
Meanwhile, it should be remembered that U.S. fiscal policymakers will have the shortest of windows to come to agreement even on merely delaying sharp fiscal tightening at the start of 2013 that is present law. Along with the depletion of the capacity to raise the U.S. debt ceiling without the full ascent of Congress, a great deal of drama or worse on the U.S. policy front should be on display late this year.
Investors might simply ignore the risks until or unless any one of the shocks we mentioned (or others) takes place. In the event that a shock doesn’t occur, it could very likely pay off. But then again, there may be fewer bullish investors by the time that drama plays out.
I see no reason why investors should be optimistic. As we recently found out, President Obama is fairly comfortable with the idea of letting all the Bush tax cuts expire. That would not be a good idea. A few years back, Goldman Sachs ran a study looking at what would happen if all the 2001 and 2003 tax cuts were repealed at the end of 2010. As I wrote:
Using the Washington University Macro Model, Goldman reset the tax code to its pre-Bush status, assumed all tax cuts expired, and watched how the economy reacted as 2011 began. What did the firm see? Well, in the first quarter of 2011 the economy dropped 3 percentage points below what it would have been otherwise. “Absent a tailwind to growth from some other source,” the analysis concludes, “this would almost surely mark the onset of a recession.”
But wouldn’t the Federal Reserve jump in and cut interest rates, offsetting the fiscal drag of the tax hikes with easy monetary policy? The Goldman Sachs experiment assumes it would, but WUMM still shows the economy sinking: “In an effort to resuscitate demand, the Fed immediately cuts the federal funds rate, bringing it 250 basis points below the status quo level over the next year and one-half … Despite this, output growth remains well below trend over that period, putting downward pressure on inflation as slack in the economy increases.”
And the last time I checked, the Fed doesn’t have 250 basis points of Fed funds rates to cut these days. Maybe QE3?