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.
Meet Anthony Mirhaydari at the MoneyShow Las Vegas
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