The Fiscal Stiff

US Vice President Biden and Senate Minority leader McConnell brokered an agreement that was approved by the Senate that seems to avoid the full fiscal cliff. It now is before the House of Representatives.

While the Jan 1 deadline is passed, the more significant one, we had argued, was Jan 3, when a new Congress is sworn in. A failure by the 112th Congress to finalize the legislation would mean that process would have to begin anew with the 113th Congress.

After what is likely to be intense though short debate, the House of Representatives can either approve the same exact bill the Senate approved, which would be the quickest resolution. It can seek to amend the bill, in which case the bill must return to the Senate for their approval. The process could be cumbersome, require reconciliation and would risk the Jan 3 deadline. Alternatively, a majority of the House could fail to ratify the Senate bill, in which case, it will be up the next Congress to claw back from the other side of the cliff.

This sketches the procedural course in the coming days; let's turn to the substance of the Senate deal. The key highlights include, a 4.6 percentage point increase (to 39.6%) the marginal tax rate on those households earning more than $450k ($400k for individuals), tax deductions. Although credits begin phasing out on $250k incomes, the dividend and capital gains tax will only be hiked to 20% (from 15%) on households earning $450k ($400k for individuals). The payrolls saving tax, which had been reduced by 2 percentage points during the financial crisis, will be restored to 6.2%, which will impact all private sector employees. There was full year extension in unemployment compensation. The Alternative Minimum Tax was permanently indexed for inflation. It delays a 27% cut in payments to Medicare providers for a year.

One of the reasons why this agreement is not a slam dunk in the House of Representatives, once over the hump of tax increases, is that there are no spending cuts. Instead the Senate agreed to delay for two-months the $110 bln in the automatic spending cuts that were part of the fiscal cliff. Even the $30 bln for the extension of the unemployment benefits has not been offset with spending cuts. The idea being that after a cooling off period, fresh negotiations will be required to secure spending cuts.

On the other hand, one of the reasons that the Republicans can approve the bill is that they may still have a trump card: the debt ceiling. The federal government reached the debt ceiling at the start of the week, which limits the government's ability to borrow. The US Treasury has begun taking "extraordinary measures" to minimize the immediate impact. These maneuverings are not limitless, but can buy several weeks. It appears that an increase in the debt ceiling is needed by late February or early March, though creativity of properly incentivized politicians and bureaucrats should not be under-estimated.

We have outlined the procedural process, the substance and limits of the agreement, now let's briefly sketch out an evaluation.

1. The capital markets seemed to generally looked past the self-inflicted fiscal cliff debate in the US. As we have noted, fiscal consolidation was not being forced on the US via a capital strike the way it was in the periphery of Europe. It was more a political problem than an economic problem. Yet, until the House of Representatives play their hand, there may be not big market reaction. This is also consistent with the thinner market conditions. The economic data in the coming days features the monthly PMI readings and US auto sales and employment report (at the end of the week).

2. The economic slowdown that the US appears to have experienced in Q4, which appears to have slowed to half of the 3.1% pace seen in Q3, is more a product of inventory draw down, rather than the uncertainty of the fiscal cliff. Core durable goods orders rose at a healthy clip in Oct and Nov and private sector job growth did not slow. Without going fully off the cliff, we continue to expect the US economy to be among the strongest in the G7 in 2013 with a little more than 2% growth. The ECB and EC have successfully reduced some of the extreme tail risk in Europe. China's economy has begun strengthening. These three issues had been among the chief concerns for investors.

3. We had thought investors would have a sense of closure on US fiscal policy early in the new year. Now it does not seem likely until late Q1. In a larger sense, many structural issues that are needed to ensure the US is on sounder fiscal footing, while at the same time, addressing the weakness in its physical infrastructure and ensuring people have skills necessary to participate in competitive marketplace, have not been addressed.

4. Many Republicans will not be happy with the agreement, but Obama had all the cards. The Democrats have the executive branch and a majority in the Senate. While the Republicans enjoy a majority in the House of Representatives, Democrat candidates as a whole actually received more votes. Moreover the Republicans are split as the failure of Boehner's Plan B illustrated. Ironically, the split is very much like in the German Greens. There is a realos faction that wants to govern. There is a fundos faction that puts principle ahead.

5. The real question is why didn't Obama push his full advantage? The answer, as we have implied before, on economic policy Obama is not very different than some Republicans. Others, like Bruce Bartlett, an official in the Reagan and Bush I governments, recognizes this in a piece in the Fiscal Times "How Democrats became Liberal Republicans". None less than Obama himself recognizes this. He explained recently to a Hispanic audience that he was not a socialist as some of his critics assert, but rather his economic policies, would have made him a moderate Republican in the 1980s.

6. One of the great unspoken truths during a debate that seemed to speak a lot of untruths is that the raising of the taxes on the wealthy (however defined) is not sufficient to close a $1 trillion deficit or reduce the America's debt. The driving value was not fiscal correctness, but a sense of fairness. The concentration of wealth and income in the US increased during the credit crisis (and some like ourselves and others, like Jim Livingston at Rutgers, see it as a critical cause of the crisis) and is increasing in the post-crisis period.