Why the Fiscal Cliff Will Happen... For About a Week

Alexander Green
by Alexander Green, Chief Investment Strategist

A few weeks ago, The Oxford Club held its special Post-Election Conference at the luxurious Willard Intercontinental Hotel in Washington, D.C.

We were there to talk about the election results and how they are likely to impact your stock portfolio in the months ahead. Here is a brief re-cap of my analysis.

Before the election, the Democrats controlled the Senate, the Republicans controlled the House and Obama was in the White House. The same is true today. This is dispiriting to many, not least of all because this is the same gang that has dithered on important policy issues, spent like drunken sailors, and generally hampered the recovery over the last two years.

There are good reasons for optimism, however, beginning with the so-called “fiscal cliff,” approximately $600 billion in automatic tax increases and spending cuts set to take place beginning January 1.

How can this be good? First, because it isn’t going to happen. And, second, because it will set the stage for genuine reform. Here’s what I mean…

The first rule for an educated citizenry is to forget everything your politicians say and watch only what they do. And what they are not going to do right now – despite the claims of the fear mongers and propagandists on both sides of the aisle – is throw the economy back into recession by letting the fiscal cliff become a reality.

I know both politicians in both parties are saying they are far apart but this is simply how the game is played. In particular, if Republicans are going to cave on their promise not to raise taxes they have to wait until after January 1. Why? Because then the top tax rate rises to 39.6% automatically.

Once it becomes law, they can restore all the Bush tax cuts except for the top 2%, lower their new top rate to, say 38%, and try to save face by claiming they cut the top tax rate instead of raising it. (Even though it will be higher than the current top rate of 35%.)

Cynical? Yes. Wrong-headed? Yes, but it is likely to happen anyway. Polls show that 60% of voters will blame Republicans if everyone’s taxes go up.

As for the spending, let’s get real. Republicans and Democrats have never had a problem coming together to let federal spending flow and this time isn’t likely to be any different.

This compromise – which we are likely to see fairly quickly – will only be a short-term patch by a lame duck Congress. But when the new Congress comes to town, expect to see something like Simpson-Bowles II. Only this time Obama isn’t likely to ignore the bipartisan commission’s budgetary and entitlement reform proposals.

You’re skeptical? Don’t be. Obama owns this budget deficit now. He knows that if he doesn’t do something about the long-term fiscal crisis we face, his legacy will be mud.

Bill Clinton, for instance, was no Ronald Reagan. But he did cut the capital gains tax, reform welfare, sign NAFTA into law and preside over a budget surplus. Clearly, it is possible for a Democratic administration to sign pro-business, free-market reforms.

There’s an old saying in politics: “Only Nixon could go to China.” The implication is that only someone like Richard Nixon, a man of unquestioned anti-Communist convictions, could reach out 40 years ago and engage constructively with the Chinese without fear of being labeled an appeaser.

Expect something similar in Obama’s second term. Perhaps only a man clearly committed to a strong social welfare network can rein in runaway entitlement spending without being labeled heartless, uncompassionate, or a toady of the rich.

Exactly how we’ll get there is unclear, but reforms will almost certainly include some combination of delayed eligibility for future recipients, means testing, spending cuts and increased revenue. Neither the right nor the left will be entirely satisfied with the result – and there will be plenty of name-calling and hyperbole before we get there – but that’s why we call it compromise.

In short, the real looming crisis is not the fiscal cliff on January 1. It’s the current entitlement system that – in its present form – is absolutely guaranteed to come undone by time and arithmetic.

Progress on this front – which we are likely to see next year – will be good for the dollar, good for the stock market, and good for the future of the United States.

Govern your portfolio accordingly.

Good Investing,

Alex

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