After years of avoiding tough choices on the debt and the deficit, a reckoning is upon us. The outlook is bad, but there is a glimmer of hope.
With a time bomb ticking, America seems to face a terrible choice: fiscal austerity and recession, or denial mixed with more debt and a new credit downgrade. A decision must be made soon; we will reach the "fiscal cliff" on Jan. 1, and the nation will hit the $16.4 trillion debt ceiling limit in January or February.
But all is not lost. In fact, a true solution is possible. I'll outline it below and then offer some initial advice to investors.
Politicians, you've been warned
Time is running out.
Yet as deadlines approach, the leaders we've tasked with finding a solution are engaged in a political blood feud and can agree on little, if anything.
They've bungled their responses to the smaller, incremental events that helped get us here, including past battles over the debt ceiling, extending the Bush tax cuts and lengthening unemployment benefits, as well as the failure of the congressional deficit supercommittee.
Now, tougher choices are stacked up just ahead, like piles of dynamite, awaiting the election, the lame-duck session of Congress and, potentially, a lame-duck president.
Anthony Mirhaydari
The credit-rating agencies are not pleased. Fitch warns that the fiscal outlook is "mired in uncertainty" and that indecision threatens America's rating. Standard & Poor's cut our AAA rating in August 2011, to great financial turmoil and economic damage, in large part because of the dysfunction surrounding that summer's battle over the debt ceiling.
S&P has promised to take additional action unless the country starts making real, structural progress on its debt and deficit problems and addresses the "recent decline in the effectiveness, stability, and predictability of its policymaking and political institutions, particularly regarding the direction of fiscal policy."
Business leaders are not pleased. CEO confidence and plans for capital spending are way down. The August report on durable goods orders -- machinery and equipment -- dropped at a rate not seem since the depths of the financial crisis. Hiring plans are down. Factory activity is down. New orders in the Federal Reserve's regional activity surveys are down.
A Merrill Lynch survey of chief financial officers found that the "effectiveness of U.S. government leaders" is their No. 1 concern right now. In July, a U.S. Chamber of Commerce survey of small businesses found that 65% were "very concerned" about the cliff. It's no surprise that job growth, based on the payroll report rather than the volatile household survey, has stalled or that a large portion of the jobs being created are part time.
And increasingly, investors are not pleased. A Merrill Lynch survey of U.S. fund managers shows the cliff at the top of their list of concerns, as issues such as the eurozone debt crisis, Iranian-Israeli saber-rattling and the Chinese housing market fade. The fiscal cliff is also the top concern of currency and credit traders, as well as European fund managers.
In other words, even with Spain on the brink of a bailout and Greece desperate for another injection of German cash, managers in Madrid and Athens are increasingly looking to Washington -- with a sinking feeling in their stomachs.
Falling off the cliff
Europeans are all too familiar with the risks.
If Congress and the White House take no action, the cliff will result in a fiscal body blow totaling $720 billion, which is worth nearly 5% of gross domestic product. (The numbers, and some options laid out by Merrill Lynch experts, are shown in the chart below.) This includes a $120 billion hit as the payroll tax cuts -- which started in 2009 as the Making Work Pay tax credit -- expire; $110 billion in budget cuts known as "sequestration" tied to the supercommittee's failure, which will hit the Pentagon hard; and $200 billion in tax increases as the Bush tax cuts expire and Obamacare taxes on the wealthy kick in.
However you add it up -- Merrill outlined three options -- this is a serious economic hit.
With the economy now managing to grow at only a 1.3% annual pace -- despite massive and repeated doses of cheap-money, dollar-weakening, inflation-priming stimulus from the Fed -- you don't have to be an economist to realize this would raise the threat of recession and start unwinding hard-won progress in the job and housing markets.
If you add in the additional drags from financial market turmoil (remember last summer's market dump related to the S&P credit downgrade?) and lost business and consumer confidence, it's an ugly outlook.
Oh, and it gets worse.
You see, we're not alone in facing this fiscal reckoning. France, Italy, the United Kingdom and Spain are all expected to tighten their budgets by 1% of GDP or more next year as the sun sets on the era of unmitigated borrowing and spending by governments. Germany, Canada and Japan are also tightening their belts. This is the kind of globally synchronized, demand-destroying policy tightening the made the Great Depression so terrible.
Overall, the International Monetary Fund expects the advanced economies to continue such policies through at least 2015.
The bite of austerity
There's more.
Economic experts have long debated just how austerity via tax hikes and spending cuts would affect an economy. For a while, many, especially in Europe and in the far-right wing of the Republican Party in the United States, believed that budget cuts could actually spur growth by boosting confidence. The discussion focused on what's called the "fiscal multiplier," a measure of the severity of the real impact of those tax hikes and spending cuts.
Clearly, the fantasy of expansionary austerity has been proved wrong by what's happening in Europe and the U.K. So the multiplier is a positive number, meaning tax hikes and spending cuts actually hurt growth.
Here's the thing: The IMF and others believed the multiplier was around 0.50 or so, meaning that a 1% tax hike would result in a 0.5% drag on GDP growth.
That appears to be wrong, too. Given the current economic situation of low growth, excess capacity, long-term unemployment, ultralow interest rates and over-indebtedness, the current multipliers are believed to be higher -- much higher.
In its latest economic outlook, the IMF's chief economist laid out the case that the multiplier could be as high as 1.7. So that 1% tax hike would result in a 1.7% drag on growth. And given what we've seen in Greece, the U.K. and Spain, larger multipliers seem more likely. This is backed up by research from other economists all saying the same thing: Multipliers seem to be higher than 1.
So you see, even if Washington finds a middling solution, such as any of the three scenarios Merrill Lynch outlines in the table on the previous page, the impact will still be powerfully negative. It would be a game of pick your poison, depending on which of the three potential compromise deals Congress and the White House could reach.
But even then, the market could still react negatively to the drag on growth. Merrill Lynch's Priya Misra estimates that only about $40 billion to $80 billion of fiscal tightening is priced into the Treasury bond market, even as the Merrill Lynch team expects $300 billion or more in tightening.
Simply put, even if we assume Washington can hammer out a deal early enough to settle the stock market turmoil and avoid more credit downgrades, we're still looking at a drag on economic growth of between 2% and 3.4% of GDP next year.
Among the impacts: The unemployment rate wouldn't stay under 8% for long.
Yet denial isn't an option. If the fiscal cliff is ignored and all the tightening I've discussed avoided, the bipartisan Committee for a Responsible Federal Budget believes the nation's debt held by the public would grow by an additional $7.5 trillion through 2022 -- an increase of nearly 70% over the next 10 years. The negative impact of more and more sovereign debt is well documented in the academic literature. In plain English, it's hard to pay down debt -- and the deeper into debt you go, the harder it becomes, because your economy gets weaker and weaker.
The escape hatch
Now that the situation appears hopeless, let me try to talk you off the ledge. There is still a narrow window of escape from this mess. The broad outlines are:
- A pro-growth, revenue-neutral tax plan such as the one promised by Mitt Romney (and an idea that has attracted bipartisan support in that past) that boosts CEO and small business confidence and encourages a bounce-back in corporate spending, capital expenditures and hiring. This will help growth and will ease the pain of closing the deficit. This was the subject of a column I wrote two weeks ago.
- An end to one-time tax credits (research shows they are of marginal value) such as the temporary payroll tax cuts and temporary R&D credits. Or, if they're worthy, make them permanent.
- A solution to the true source of America's long-term, structural fiscal deficit: out-of-control health-care cost inflation and unfunded entitlements. As things stand, the Congressional Budget Office believes the cost of government health care spending will grow from 5.4% of GDP now to 12% by 2055.
I prefer the Republicans' market-based solutions, which rely on increased competition and promote price transparency, to the Democrats' government-based solutions. But something needs to be done, even if it's a European-style single-payer system that uses bureaucratic rationing instead of free-market price rationing. Our current system is broken and bankrupting the country.
Another quick note on health care: Before you say that the cost is worth it, given the quality of our care, that's just not true. Deutsche Bank notes that on a per-capita basis, America already puts "far more resources into health care than any other country, and gets less for it on a number of different standards."
You can see this in international comparisons on measures like deaths from medical errors and life expectancy, as well as the lack of correlation between the level of Medicare spending per beneficiary and quality of care across the 50 states.
And before people get upset at the term "entitlements," know that a typical middle-class couple retiring in 2010 is on track to collect $387,000 in Medicare benefits after paying in only $156,000 in taxes.
Meanwhile, back in your portfolio
So what are investors to do while the road to the cliff unfolds?
The dramatic breakdown of the major market averages this week, with the Dow Jones Industrial Average ($INDU) collapsing below key levels as money poured into safe havens like U.S. Treasury bonds, feels very similar to last August's meltdown.
I don't put a lot of faith in Washington to find a solution until confidence is shaken even further, stocks are plummeting and joblessness starts rising again.
So as an investor, now is the time to be getting defensive and raising cash. If you're more nimble, there are short-side opportunities in energy and foreign stocks, while on the long side, Treasury bonds are looking attractive (which seems counterintuitive since the Treasury has a fiscal problem, but that's just how things work).
My recent recommendations include the ProShares UltraShort Oil & Gas (DUG), ProShares UltraShort MSCI Brazil (BZQ) and Direxion Daily 20+ Year Treasury Bull 3x (TMF) exchange-traded funds. (You can see current positions in my Edge Letter Sample Portfolio.)
No one said breaking the addiction to cheap borrowing, easy spending and subsidized health care would be easy. But it's necessary.
At the time of publication, Anthony Mirhaydari did not own or control shares of any fund mentioned in this column in his personal portfolio. He has recommended the ProShares UltraShort Oil & Gas, ProShares UltraShort MSCI Brazil and Direxion Daily 20+ Year Treasury Bull 3x ETFs to his clients.
Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.
