Interview With Ed Deak: 60% Chance We'll Go Over The Fiscal Cliff, Risking Recession

Includes: DIA, QQQ, SPY
by: Harlan Levy

Edward Deak is a Fairfield University economics professor emeritus and the Connecticut model manager for the New England Economic Partnership, which produces a semi-annual New England forecast.

Harlan Levy: Do you think Congress will stop us from going over the economy's fiscal cliff?

Ed Deak: I'm not as optimistic as some that there will be a resolution to the problems before Jan. 1. You cannot exaggerate the seriousness of the problems we are facing with the fiscal cliff. Even though Congress was able to work out a compromise in 2010, I suspect that we will in fact go over the cliff for some period in January, and you have to keep in mind that the new Congress won't be sworn in until Jan. 20. So if we do go over the cliff, and I think there's about a 60 percent chance that we will, we run the risk of putting the U.S. economy back into a recession.

Certainly President Obama is sticking by his insistence on raising taxes for every couple making over $250,000 a year, and Republicans are insisting they will not accept that as any part of a compromise. Also, there is no inclination in Washington to keep the 2 percent temporary tax cut on Social Security payments for every working American. There are other provisions, such as the extended unemployment benefits, the compromise on the alternative minimum tax to keep middle class families from feeling that burden, and the compromise on the extension of the debt ceiling.

All of these have to be part of a negotiated package along with the Bush tax cuts that expire Dec. 31. It seems unlikely that a resolution of all those issues can take place between Thanksgiving and Christmas. Going over the cliff will be a serious drag on both the U.S. and Connecticut's economies. It's nothing to be pleased about.

H.L.: What would happen to Connecticut and other states?

E.D.: First off, sequestration, the withholding of these $1.2 trillion in appropriated funds, will have serious effects on state defense employers. It will also withhold funds for social services, and the higher taxes on high-income individuals will hit Connecticut disproportionately. And because there would be no resolution on the Bush tax cuts, the marriage penalty provisions would be reimposed: Filing jointly as a married couple you would pay more than filing separately. And the child tax credit would be substantially reduced.

The Obamacare provisions going into effect in 2013 would also potentially have an adverse influence on health insurers like Cigna (NYSE:CI) and Aetna (NYSE:AET) and medical equipment suppliers like Covidien (COV), formerly U.S. Surgical. The insurers will have to compete with health exchanges, a way individuals will be able to buy insurance under Obamacare. They are to be established in each state or by the federal government, and they will make the purchase of insurance more competitive and may cut profit margins for the insurers.

By the way, gainers include about 380,000 Connecticut residents who are not currently covered by health insurance, around two-thirds of whom would be able to purchase health insurance under Obamacare. Another gainer would be hospitals, where almost all patients will be covered by health insurance. The hospitals won't be stuck with bills for emergency room services for uninsured patients who don't pay.

H.L.: Do you think Congress will come up with effective tax reform?

E.D.: It's going to have to sooner or later, because the federal budgets are so out of balance for the next 10 years that the federal government won't be able to sustain annual borrowing levels and the interest payments on outstanding debt too far into the future. The reform of the tax code will also most likely involve some changes in Social Security, Medicare, and Medicaid. How and when Washington finds the political will to revise the tax code and make these changes is anybody's guess. It won't happen when they fix the fiscal cliff. They'll probably create another commission and postpone the pain until sometime down the road.

H.L.: How can Congress find the will to fix entitlement spending and reform the tax code?

E.D.: Most likely the political will would come from an outside panel of independent and impartial professionals who would propose a comprehensive solution which would then mandate an up-or-down vote in the House and the Senate.

H.L.: Do you think the deduction for interest on home mortgages will survive?

E.D.: It will be more limited than it is now. I think all of the deductions will.

H.L.: Do you think the capital gains tax rate will rise?

E.D.: To some extent, but not in its present form. Traditional capital gains may be taxed at 20-plus percent instead of 15 percent.

H.L.: How do you think entitlement reform should go and will go?

E.D.: Social Security and Medicare must become more means-tested. For example, the full Medicare coverage qualifying age may be raised from 65 to say, 67, with partial coverage from 65 to 67. Medicaid - the health insurance for low-income and indigent Americans paid for by both state and federal funds - can't be a bottomless pit for everyone who needs medical care, so some constraint will have to be introduced, because it is severely impacting individual state budgets.

H.L.: What growth do you predict for the U.S. economy this year and next year?

E.D.: This year we're going to have a little more than 2 percent, and if we avoid the actual reemergence of a recession and we fix the fiscal cliff early enough in 2013 we'll probably see between 2 and 2.5 percent growth in 2013. If we really do a credible job at fixing the fiscal cliff, reforming the tax code, and dealing with entitlement spending, it would not be surprising to see 3 to 4-plus percent in 2014 to 2016.

H.L.: What do you see for stocks?

E.D.: As long as the U.S. economy avoids a double-dip recession, the Dow Jones Industrial Average should remain around 13,000 growing slowly in 2013.

H.L.: What do you predict will happen to the sovereign debt problems in Europe?

E.D.: Most likely the European Central Bank will step in even more forcefully than it has to provide temporary financial support for Greece and other floundering national debtors and help recapitalize the European banks. Of course, that increase in money along with the increase in money created by the Federal Reserve in the U.S. sets up the potential of a strong dose of global inflation in the second half of this decade.

That may be bad, but you have to take care of today's problems today, and today's problem in Europe is keeping the euro zone together. Today's problem in the U.S. is putting people back to work. They're both being dealt with by central banks creating money.

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