Pessimism and the Fiscal Cliff

Though I tend to only read the Daily Mail for celebrity news and updates in the English tabloids, I opened the site today and discovered a significantly more weighty headline: "INVESTMENT EXTRA: Why ordinary investors should not put their money in to the US." It's certainly not uncommon for the Brits to bash Americans, but most of this talk tends to be about the political system, the southern "cowboy" culture, or the inordinate number of fast food restaurants. This time, however, it wasn't just playful banter.

According to this piece by James Coney, the so-called "fiscal cliff" isn't just spreading worry throughout the U.S. public and private sector--it is also reaching important sources of capital overseas. Although the election of a new president tends to boost enthusiasm and confidence in the U.S. economy, on Wednesday, November 7th, people had already turned their attention to the impending crunch. Put simply, this fiscal cliff involves a large bundle of spending cuts and tax hikes that will all take effect on January 1, 2013.  A CNN article released that day called this the "single biggest problem facing the United States," using the explanatory metaphor of a speeding car driving off of a cliff.

If no policy changes are made to avert the impending fiscal cliff, many fear that it could spell the ruin of not only American markets and businesses, but also those across the international economy. Once the new year arrives, a slew of spending cuts are slated to take place, affecting the defense sector and including several other discretionary cuts. Unfortunately, this is the inevitable fallout of the failed budget summit a while back. Compounding this is a number of tax hikes, which are caused by the expiration of the Bush era tax cuts. Within this, there will be a lowering of the Alternative Minimum Tax, which would push millions of families over the threshold into a higher income tax bracket. Altogether, this is projected to cause a $7 million increase in taxes over the next ten years, and siphon anywhere from $5 trillion to $7 trillion out of the U.S. economy. If this country "falls" completely off of the fiscal cliff, experts estimate that it will cut the GDP by 3-4%, which will undoubtedly cause recession in an economy that is currently only growing at 2-3%.

Just after President Obama's reelection, there was an unusually low level of chatter about the actual election results. Instead, almost instantaneously, people shifted their attention to the hopeful resolution of this fiscal cliff. With the administration set for another four years, both Republicans and Democrats are calling for this problem to be fixed right away--not only to avert the crisis that would come crashing down on January 1, but also to avoid the immediate problems associated with lack of confidence. As Christine Lagarde, head of the IMF, noted, the fiscal cliff has already caused huge uncertainty across the world, with major financial players unsure of how things will unfold.

Last Wednesday, both sides of the aisle were noting the sudden jolt to the Dow Industrial Average, and began speculation that the U.S. economy was headed for another downturn. The Daily Mail piece highlighted this uneasiness, putting forth five concrete reasons why investors should not continue to direct their money to American industries. First, the fiscal cliff will be difficult to avoid, and with unemployment already at 8%, there will be "lower consumer spending and higher state benefits." Additionally, entitlement spending is only expected to increase, profit margins are inflated and vulnerable, and it is difficult to find reliable, skilled fund managers in the U.S. Finally, the article questioned why anyone would choose an American fund when "some of the best global funds already hold masses of American stocks."

 The fiscal cliff is engendering anxiety in East Asia as well. Far worse than any of the China rhetoric tossed around in the debates, the threat of another significant domestic downturn would hurt the vital economic relationships between China and the U.S. Chinese leaders have expressed concern that the U.S. will "drag them down with it," and have made calls for Obama to abandon the political posturing and develop a more "constructive" relationship with them. According to Shaun Rein of China Market Research Group, "Regardless the leader, China needs the U.S. economy to prosper in order to keep export flowing and U.S. investment in China high -- which are important ingredients Beijing needs as it attempts to boost Chinese wages and beef domestic spending." In other words, China sees the threat of the fiscal cliff as a sort of mutually-assured destruction.

Put frankly, articles like these should cause mild alarm. When public, international news sources are calling for investors not to put their funds toward American endeavors, people should realize that change needs to be accomplished--and soon. Realistically, however, it is unlikely that things will unfold in such a detrimental fashion come January 2013. The American news media is marked by its obsession with all things "doomsday," and such hugely important issues tend to get priority on the President and Congress' to-do list. While I do not believe the U.S. will go tumbling down the fiscal cliff, all the way into the gorge of recession and complete stagnation, it would not be right to write off these pieces as overly-exaggerating. Perhaps the biggest worry with the fiscal cliff is not what could happen at the turn of the year, but rather what is already happening now: a rapid decline in confidence.

What John Maynard Keynes called "animal spirits" are alive and well, functioning sometimes to the benefit and other times to the total destruction of an economy. As John Cassidy notes in his book (discussed in the previous post), group psychology can explain many of the happenings in markets and can predict the behavior of one or multiple players in a given situation. In many past recessions and depressions, a permeating lack of confidence--starting quietly and then reaching critical mass--has been the main factor that tips the scales. Once this cycle has begun, it is extremely hard to encourage consumers to loosen their fists and re-start a pattern of spending. In the Thai example that Krugman puts forward, once there was a bit of trouble with households and businesses, investors quickly lost faith and jumped ship. This left Thailand in shambles, with a devalued currency and a reeling economy.

Once investors begin to lose confidence in the U.S., it could spread like wildfire. If significant, public steps are not made to remedy this situation and avoid playing chicken with the fiscal cliff, the U.S. should not hope to get out of the recession anytime soon. And, depending on the severity of this sentiment, the global economy could potentially worsen instead of heal. The actual impact of the spending cuts and tax increases should not be the main worry; rather, it should be the fore-running consequences, and the possible cycle of lack of confidence that could greatly increase the negative impact of these policies. If the threat of the fiscal cliff is not eliminated and potential investors' worries not allayed, all of the major players in the global economy could feel its impact.