Fix the Debt!
November 19, 2012

In the “normal” course of a U.S. election, investors typically breathe a sigh of relief when the results come in, with at least one layer of market uncertainty removed. This time around, the political squabbling hasn’t ended with the close of the polls on November 6. The debate about the “fiscal cliff,” a combination of spending cuts and tax hikes set to go into effect on January 1, 2013, has heightened.  Market volatility since the election seems to have heightened, too.

Will an 11th hour deal be reached to stop some or all of these measures from taking effect? And if they do come to fruition, what would be the economic consequences? Christopher Molumphy, Executive Vice President and CIO of the Franklin Templeton Fixed Income Group®, expects politicians will probably reach some sort of fiscal-cliff compromise deal, but it may not solve the bigger issue: fixing the debt. 

Christopher Molumphy

In 2011, Congress was locked in a stalemate over a workable deficit reduction plan, and enacted what is formally known as the Budget Control Act of 2011 (the “Act”). The Act outlines a roughly $600 billion combination of spending cuts and tax increases that will automatically go into effect January 1, 2013, if Congress fails to reach an alternative deal. The measures are expected to result in economic fallout—and therefore dubbed the “fiscal cliff.” How did the U.S. wind up at the edge of the cliff? Molumphy puts it simply as “procrastination.”  And, it’s no grand revelation that procrastinating can have painful consequences.

“We believe going off the cliff would likely throw the economy into recession, at least during the first half of 2013.”

“These are not new issues; we’ve known about them for some time. We just chose not to deal with them. So, now here we are with a deadline looming. The fiscal cliff measures represent approximately 4% of U.S. GDP, a significant amount with potential repercussions on economic growth, particularly given that the U.S. economy is only growing currently at about 2% (annual rate). We believe going off the cliff would likely throw the economy into recession, at least during the first half of 2013. Coming off an extremely painful recession three years ago and a difficult recovery since then, I don’t see much appetite, political or otherwise, to go through that. It’s an unpalatable solution to solve our debt problems, and we don’t think it will likely occur.”

Molumphy is optimistic a deal will be struck to avert most of the spending cuts and tax increases outlined in the Act.

“We think the most likely scenario is that the vast majority of the fiscal cliff components will be pushed off into the future and we will avert a worst-case scenario. That doesn’t mean we won’t see contentious negotiating going on over the next weeks and months, and it could go right until the last hour. It wouldn’t surprise us to see it going beyond Jan. 1, technically going ‘off the cliff.’ But in our view, the most likely scenario is a negotiated final resolution.

Why do we see that? The problems are now in full view, and typically when everything is on the table and most of the parties agree something shouldn’t happen, ultimately it is averted. I think there is broad agreement that we should in fact not put all of these tax increases and fiscal reductions into place given the current economic situation.”

“We think the most likely scenario is that the vast majority of the fiscal cliff components will be pushed off into the future and we will avert a worst-case scenario.”

On paper, allowing all the outlined tax and spending measures to go into effect might seem like a logical way to shrink the $1 trillion annual deficit, as it would theoretically reduce it by more than half. In Molumphy’s view, this would not be the right approach.

“When taxes increase, we assume all the revenue will just pour in, but people, including businesses and small businesses, react to higher tax rates and adjust their behavior accordingly. So on paper it may look one way, but in reality, we don’t believe it would be as successful. The key point though is how to prudently solve our debt problem. Will U.S. leaders come up with a credible plan to reduce the debt, or will they just kick the can down the road? We’ve run four consecutive years with an annual deficit in excess of $1 trillion and during that period our total debt has moved from under 40% of GDP to an excess of 70%. In our opinion, we are starting to get into territory we think is much more dangerous.”

That all said, Molumphy believes there are a few reasons to be optimistic about the U.S. economy, assuming a worst-case scenario is averted and some sort of fiscal cliff resolution does come to pass in the coming weeks or months.

“The International Monetary Fund came out with projections for U.S. and global growth, and we generally agree with those projections. Of the developed countries, 2% (GDP growth) in the U.S. in 2013 looks pretty good relative to Europe and Japan. While there are some headwinds in the U.S., the U.S. consumer has done a pretty good job of deleveraging over the past several years, employment has been slowly improving, the corporate sector looks pretty healthy financially, and the housing market appears to have bottomed and should be improving.”

A lot is at stake—the ratings agencies are watching these developments, and so are the global markets.

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