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I recently wrote an article for Futures Magazine -- The Fiscal Cliff Catch -22 -- where I compared the dilemma faced by Congress and the President to Joseph Heller's "catch-22". For those unfamiliar with Heller's "catch -22", this excerpt from the novel explains the rule:

"There was only one catch and that was Catch-22, which specified that a concern for one's safety in the face of dangers that were real and immediate was the process of a rational mind. Orr was crazy and could be grounded. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions. Orr would be crazy to fly more missions and sane if he didn't, but if he were sane he had to fly them. If he flew them he was crazy and didn't have to; but if he didn't want to he was sane and had to."

You see, the idea that a proposal that would serve to avert recession by avoiding the tax hikes and spending cuts is every bit as circular in logic as Heller's "catch-22". The problem is set up best by the Congressional Budget Office (CBO) report -"Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013:

"Growing debt would increase the likelihood of a sudden fiscal crisis, during which investors would lose confidence in the government's ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates. Such a crisis would confront policymakers with extremely difficult choices. Again, the current high level of debt relative to the size of the economy means that further substantial increases in debt would be especially risky in this regard.

Therefore, eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years would have substantial economic costs over the longer run. However, as shown earlier in this report, allowing the full measure of fiscal restraint now embodied in current law to take effect next year would have substantial economic costs in the short run."

The CBO's position is this -- growing debt could precipitate a financial crisis but tax hikes and spending cuts could also precipitate a financial crisis. In my mind that means we are damned if we do and damned if we don't. As Heller points out in his novel, Orr was in the same situation - a real "catch-22" dilemma.

Monday's run up in stock prices seems to imply that investors are only concerned with rhetoric, not a legitimate resolution to this dilemma. Apparently, if we arrive at a solution that we refer to as "avoiding the fiscal cliff" all will be fine and the economic reality of the impact of that solution is not really relevant.

As an investor that sees the "fiscal cliff" matter with objective clarity, it bothers me that stocks are being driven higher -- on extremely light volume -- on the idea that a solution exists that will avoid the "fiscal cliff's" negative impact and justifies much higher stock prices. Investors that buy the top of the market based on irrational euphoria predicated on a resolution of the "fiscal cliff" matter are going to be sorely disappointed in short order.

If this is not the case then maybe we should just conclude that the stock market in recent times has become nothing more than a casino game and market movements are based on random chance and not economic conditions. That bothers me a lot as it shouldn't be that way.

This euphoric giddiness -- operating on the premise that "bad is good" -- relegates another one of our treasured institutions to a position of dysfunctional and meaningless irrelevance. We should expect the stock market to reflect real economic conditions - at least to the extent that we understand them, and we certainly do understand the implications of the "fiscal cliff".

I think maybe we need to take a look at the most recent proposal that is on the table to see how it alters the economic landscape. First, we need to understand the situation as it exists at the present time. The "fiscal cliff" was created in 2011 as an attempt to deal with the out of control trajectory of the debt and deficit. Back then we all recognized that a continuation of the "borrow and spend" policy of recent years was simply unsustainable. That position is understood by almost everyone.

The solution to the problem was to let the "Bush tax cuts" expire and thereby increase revenues and to implement a series of spending cuts that would reduce the spending side of the problem. The numbers - according to the CBO - result in a total reduction in deficit spending of $607 billion. The tax hikes would result in $399 billion in deficit reduction and the spending cuts would result in another $208 billion.

The problem we are faced with today is that our economic recovery - if one can call it that and I don't -- is so fragile that we simply can't maintain positive GDP growth without continuing the borrow and spend policy of recent years. The goal of Congress and the President in recent weeks is to modify the 2011 resolution to the problem in a way that avoids recession.

Here is a simple breakdown on the math. We are growing the economy at a rate that falls somewhere between 1.5% and 2.0% at the present time. Our GDP is roughly $16 trillion a year at the present time. If we extract the full measure of tax dollars and spending cuts -- $607 billion -- from the economy in 2013 we will reduce GDP by at least a 1:1 ratio resulting in a reduction to GDP of roughly 3.7%. That would put GDP growth in solidly negative territory with the best case scenario being minus 1.7% and that assumes the 2% growth rate.

This is a very simplistic view of the matter and makes no provision for private sector cuts to spending by increased lay offs that will reduce the consumer pool even further-- and in so doing, reduce GDP even further. It also fails to take into account the impact to GDP from a reduction in sales that are beginning to show up in our trade balance figures as the eurozone and China experience their own economic contractions. In other words, it is not only possible but likely, that the full measure of current spending cuts and tax hikes will produce a negative GDP number that is significantly worse than minus 1.7%.

So, how then does the current proposal impact this situation in a way that justifies higher stock prices? Will the President's proposal work to avert recession? Let's take a look. Here is what the President is proposing:

The President's proposal provides for a continuation of the "Bush tax cuts" for taxpayers earning less than $400,000. That is assumed to generate $1.2 trillion in revenues over 10 years. Assuming a straight line allocation of the revenues over the 10 years, we would expect a total tax increase of $120 billion in 2013 - a reduction of $277 billion in the current "fiscal cliff" arrangement.

Now to the spending side - Obama's proposal calls for total cuts of approximately $1.22 trillion which is close to a 1:1 ratio of spending cuts to tax hikes. The problem is that the Obama proposal is counting spending cuts that just aren't spending cuts at all but we will look at that in a moment. For now, let's do another straight line allocation of the number to see what happens in 2013.

The straight line allocation of $1.22 trillion results in spending cuts equal to $122 billion in 2013 compared to the "fiscal cliff" arrangement that provides for $208 billion - an improvement of $86 billion. So now, how does Obama's proposal impact GDP in 2013?

Well, under the above assumptions we have revenue increases of $120 billion and spending cut decreases of $122 billion - a total of $242 billion vs. the "fiscal cliff" arrangement of $607 billion. That results in a net reduction of 1.5% to GDP and leaves us flat to plus .5% growth. And again, that assumes everything else remains unchanged.

For instance, we must necessarily assume that further cost cutting measures-- e.g., corporate lay offs-- don't occur. We must also assume that our trade balance isn't negatively impacted at all by the economic contraction in the eurozone or China. And, we must assume that our carry cost remains at the same level - a rather optimistic outlook, to say the least.

That brings me to the President's carry cost savings portion of his spending cuts breakdown -- $290 billion based apparently on a reduction in debt levels resulting from his proposal. Consider that we are at the present incurring new debt at an average of well in excess of $100 billion a month. To include that element in the proposal suggests that the President is being disingenuous as the prospect of interest rate cost reductions based on a lowered debt level is simply laughable.

Again, let's do the math. Back in 2011 Congress provided for two separate debt ceiling increases totaling $2.1 trillion. That works out to an average of $123 billion a month - considerably more than the common rhetoric from pundits that suggests we are incurring a deficit of just $1 trillion a year. Do the math for yourself. We will run out of money in January or February. That means we have borrowed and spent $2.1 trillion in 17 months.

So, how then do we assume an interest rate savings based on reduced debt levels going forward of $290 billion. That necessarily requires a reduction in total debt - not a reduction in the rate of growth of the total debt - and that just isn't happening.

The problem is compounded by the very real possibility that carry costs will increase in 2013. A 1% increase in carry costs on $16 trillion in debt is another $160 billion added to the debt. That does not impact the GDP - at least initially - but it does impact the unsustainable trajectory of the debt.

In conclusion, I would love to get on board with this altruistic giddiness at the prospects of an economic boom in 2013 that is driving stocks higher in recent days and would invite anyone to offer a scenario that supports such an outcome to the "fiscal cliff" negotiations. I just don't see it. We are an economy operating on life support - sustained only by unsustainable fiscal stimulus -- and the President's proposal -- perhaps the least damaging of the proposals on the table in the short run - will still result in significant economic contraction to GDP in 2013 and only serve to exacerbate the debt trajectory problem.

Source: Breaking Down The President's Proposal

Additional disclosure: I am short a group of tech stocks, financial stocks and crude oil. I am long the VIX.