Wednesday, 7 November 2012

Previewing Four More Years Of The Divided States Of America

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Do not expect any changes to the trends of polarization and party non-conformists is the message from JPMorgan's CIO Michael Cembalest. As he explains moderates like Blue Dog Democrats and Rockefeller Republicans are now artifacts in the Natural History Museum, having given way to their more ideological offspring (through retirement or after having been beaten in primaries).




If anything, Cembalest believes the House may become even more partisan after apparent losses by moderates in both parties.



After a better than expected night for Democrats given Senate results, the fiscal cliff looms...

With the status quo maintained, a divided government goes back to work to solve the Mutually Assured Fiscal Destruction problem. The President may have picked up some leverage over House Republicans who still have to run again, but we’ll see. The fiscal cliff does not have to get resolved by December 31, since some items can be resolved in the spring and back-dated. Defusing the cliff (see options #1 and #2) would help growth in 2013, and perhaps reignite business capital spending, which has stalled (see chart).




It would also help avoid a relapse in personal consumption, which is growing at a 2% real rate before any fiscal belt-tightening.



However, defusing the cliff contributes to rising Federal debt unless the growth payoff is huge. In recognition of that reality, 80 US CEOs published a letter calling for Washington to strike a long-term fiscal “grand bargain” that includes higher tax revenues (but not in 2013). Here’s our latest Federal debt chart as a way to visualize the problem. The contours show the Congressional Budget Office Baseline Case and Alternative Case. As explained last week, while the Baseline Case represents “current law”, it has become increasingly preposterous, since it includes items that Congress passed but has been deferring for a decade (changes to the Alternative Minimum Tax and Medicare), and a wholesale resumption of 2001 tax rates that Congress has no intention of implementing. The CBO should put a unicorn next to it as an indication of how likely it is to happen.


What might a second Obama administration do on the debt?
 
Nothing is urgent now, given plenty of public and private sector demand for Treasuries at sub-2% rates. 

However, we will have to watch how rating agencies react if the Budget Control Act Sequester is unplugged. The President’s proposal (purple square above) stabilizes the Federal debt over a ten-year horizon as per CBO forecasts, almost entirely through higher taxation on those with more than $250k in adjusted gross income (via tax increases and large reductions in allowable deductions and exemptions). The plan does not appear politically feasible given Republican control of the House. If the President only passes increases in tax rates on the top two brackets, then as shown by the green diamond, the debt does not stabilize.



House Republicans could push for more discretionary spending cuts along with tax increases, but after the caps set in the Budget Control Act, discretionary spending is already projected to be very low (chart above).



The elephant in the room is the chart above: close to 100% of US tax revenues are already eaten up by mandatory spending on entitlements and other programs, and interest. However, electoral results suggest the country is in no mood to address entitlement issues right now, will defer them to another day, and continue to shift towards a high-Federal debt economic model that bears some resemblance to Europe and Japan.

As noted last week, in the 1950’s, the solution to 80% Federal debt was not taxation, austerity or inflation, but growth. Will the President pursue a pro-growth agenda? George McGovern, who passed away recently, wrote a 1992 editorial about a post-Senate investment in the Stratford Inn (“A Politician’s Dream is a Businessman’s Nightmare”), its bankruptcy, and how he wished he had known more about the private sector and the impact of government before he took office. He wrote:
“Today we are much closer to a general acknowledgment that government must encourage business to expand and grow. Bill Clinton, Paul Tsongas, Bob Kerrey and others have, I believe, changed the debate of our party. We intuitively know that to create job opportunities, we need entrepreneurs who will risk their capital against an expected payoff. Too often, public policy does not consider whether we are choking off those opportunities.”
The capital spending decline and piles of corporate cash suggest that businesses are reacting to a slow-growth world, but may also be waiting to see which strain of the Democratic Party is embodied by a 2nd Obama administration, and its partners in the Senate. Something tells me that the ghost of the now-disbanded Democratic Leadership Council, composed of pro-growth centrists like Nunn, Robb, Breaux and McCurdy, is not about to reappear.
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