The conventional wisdom is that the re-election of President Barack Obama presages four more years of legislative deadlock on fiscal matters. At best, consensus opinion is bracing for more feckless "can kicking" and an indefinite extension of America's deficit and debt crisis; at worse, it is feared that the US could fall off of a "fiscal cliff" in the short term.
The rationale for this pessimism is not difficult to comprehend: The US has reelected the same president, and essentially the same personnel in the House of Representative and Senate that produced the sovereign debt crisis in mid 2011. Given this almost identical political configuration, why should the outcome be any different than it was in mid 2011?
In the context of the very understandable pessimism regarding the US's long-term fiscal health, I believe that the real possibilities of a "Grand Bargain" being achieved in the next few weeks / months are perhaps being overlooked. In this regard, it is important to remember that in July of 2011, a Grand Bargain that would have done a great deal to rectify the US's deficit and debt situation was almost reached. I believe that today, while the players may be the same, the historical circumstances are different - and in my view more favorable for achieving a Grand Bargain than they were in July of 2011.
Eight Reasons Why A Grand Bargain May Be Reached
There are eight reasons why I believe that a Grand Bargain could surprise financial markets and the public at large.
1. Historical perception. History is driven by context. Context, in turn, is driven by historical perception. In this regard, the breakdown of negotiations to achieve a Grand Bargain in July 2011 is widely perceived today by the public as having been a tragic historical "missed opportunity." As a result, is a profound and broad built-in consensus for a "do over." I believe it would be a mistake to underestimate the power of this profound public longing to "right this wrong" to drive events in the coming weeks and months.
2. It's perceived as fair. I believe that more than 80% of the citizens of the US would be reasonably happy to support the Grand Bargain as nearly agreed to in July 2011. Virtually all would prefer another deal. But 80% would prefer this deal to none at all. To review, these were roughly the terms: roughly $4 trillion in deficit reduction over 10 years; roughly $3 of cuts for $1 of new revenue. Most of deficit reductions on the spending side are obtained from controlling the growth of entitlements such as Social Security and Medicare. The rest of the spending restraints are broad-based and politically feasible.
On the revenue side, most of the new revenue would come from eliminating various deductions and tax loopholes. This method of raising revenues has three advantages: 1) It avoids raising tax rates, which is a politically sensitive issue; 2) It is more economically efficient than raising tax rates; 3) It is actually more progressive in terms of distributional impact since it is the rich that disproportionately benefit from deductions and loopholes.
3. It's familiar. In part, the deal in July of 2011 failed because of mistrust; not so much in each other but in themselves. The deal was so complex and its effects so difficult to predict that both sides actually seemed to mistrust whether they fully comprehended what they were signing onto. There has been a year and a half for both sides to get more comfortable with the details of the deal and exorcise fears of "Trojan Horses."
4. It's the only game in town. The Grand Bargain is based on the same principles as the Simpson-Bowles Commission plan and the plan put forth by the so-called Gang of Six. There are simply no other viable ideas out there. Most importantly, it is absolutely clear that it is not possible to balance the budget - of the sort of government that the vast majority of Americans want - without enacting both spending cuts and raising revenue. Anybody that says otherwise is lying or is misinformed. Americans have become resigned to this reality. Once it is generally accepted that any possible deal must contain both spending restraint and revenue increases then the precise details are of relatively little concern to the public at large. The vast majority of the public want a deal - any deal - and today, informed by a shared perception of history, they do not believe that any deal substantially different from the Grand Bargain is possible. This is a major factoring favoring a deal.
5. Obama needs it for his legacy; he no longer needs his electoral base. Obama is not running for president ever again, so he no longer needs to remain "loyal" to his hard core left wing "base." Historical legacy is now Obama's goal; not reelection. Most importantly, I believe Obama understands that no positive historical legacy for him is possible without a "Grand Deal" on the budget. Obama knows that history will not remember the names of any Republican "obstructionists" as the culprits of a fiscal crisis; all historical blame will be placed squarely on him if a deal is not done.
6. Republicans need a new image Tea Party to be marginalized. The Tea Party was a huge loser in the 2012 elections: It is widely perceived as having been directly responsible for the loss of at least 5-7 Republican senate seats and for having squandered a clear opportunity for Republicans to achieve a majority in the Senate. The Tea Party also boxed the GOP presidential candidate into positions on issues (e.g. immigration) that hurt him in the general election. The net result of this is that it is likely that Tea Party clout within the GOP will be substantially diminished. This will give Speaker Boehner and other Republican leaders more leeway to distance themselves from the anti-government ideology of the Tea Party and compromise revenue raising measures, something that they were loathe to do when the Tea Party was on the ascendant right after the 2010 mid-term elections. In 2010 anti-government fundamentalism was in vogue; today it's anathema.
7. Self-interest and ego. Obama wants a positive historical legacy; Boehner wants one. A Grand Bargain is the way for both of them to do it - nay, it is the only way for them to achieve it. In this quest, perfection is their enemy. Ten years from now, nobody will care about the details that will tend to bog down negotiations in the present. Political legacy rests on large historical happenings, not details. Perhaps Obama and Boehner are smart enough to realize that.
8. Polarization. If the election on November 6th proved anything it is that the US electorate is polarized. The conventional wisdom is that polarization makes compromise impossible. This view is wrong. The US constitutional system is designed to produce actionable compromise from political polarization. In the US political system, polarization can ironically help passage of a Grand Bargain. In a polarized polity, voters' preferences are more or less fixed; there is very little chance the voters will switch their votes from one party to another based on a candidate's position regarding one or a few issues. In particular, in the current political climate, virtually nothing that the politicians do in terms of moving to the center will cost them a substantial number of votes in the next election.
With the electorate polarized, the vast majority of voters on both sides are positioned in such a way that they have nowhere to go if their parties' candidates move to the center. Will the right wing all of the sudden vote Democrat or abstain if Republicans sign off on a grand bargain that raises revenues? No. If they will turn out for Moderate Mitt, they will turn out for anybody with a blue elephant pinned on their lapel. Will Obama's core coalition of progressives abandon him or abstain from voting if he agrees to a compromise with $3 of cuts to $1 in revenue raises versus a deal based on $2 to $1? No. If Democrats have deified Bill Clinton who cut welfare, signed NAFTA and balanced budgets, they will vote for anybody that has a red donkey pinned on their lapel.
If anything, with a polarized electorate split down the middle, the voices of voters at the extremes of the political spectrum make much noise, but they possess little actual clout precisely because their votes are not really in play. Therefore, the overwhelming incentive in such a polity becomes moving to the center to try to pick off the very few folks that are truly on the fence.
In sum, with an evenly divided and polarized electorate, politicians risk little in moving to the center whereas the potential incremental gains from moving to the center can be perceived as a life or death matter in the context of tightly contested and polarized electorates. In the US political system, capturing the middle provides the only real delta to gain a marginal advantage and/or possibility to achieve political glory.
On the eve of President Barack Obama's re-election, the US stock market suffered a significant drop largely based on fears of a looming fiscal crisis. It is widely believed that given the reelection of President Obama and the return of an almost identically configured congress, a fiscal crisis is highly likely. Several hundreds of billions of dollars of market capitalization evaporated with stocks such as Apple (AAPL), Exxon (XOM), and Intel (INTC) all falling by more than 3.0% while all of the major indices represented in index ETFs such as (SPY), (DIA) and (QQQ) declined by more than 2.0% on the day.
Contrary to the pervasive pessimism being reflected in Wednesday's market action, there are many logical paths that lead to a Grand Bargain in regards to the US fiscal crisis.
Thus, while I believe that there are many reasons to remain extremely cautious regarding the US equity market, and cash remains my preferred asset of choice for the medium term, I believe that the prospects of a breakthrough on a Grand Bargain are being somewhat underestimated.
Having said that, I should state that there is no contradiction between the fact that I am relatively sanguine about the prospects for a Grand Bargain and my defensive investment stance. A Grand Bargain is no panacea - it necessarily implies a major drag on the economy via fiscal policy and attendant sub-par economic growth for a very long time. Europe has proven that in highly developed and highly indebted economies, when it comes to austerity there are no free lunches. Therefore, there is really no way around the fact that, with or without a Grand Bargain, US economic growth and corporate earnings growth in the next decade will be slower than in the prior three decades. For US policy makers, it is really a matter of choosing the poison.