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Evariste Lefeuvre
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Evariste Lefeuvre is the Chief Economist of Natixis North America’sEconomic research department in New York. His primary mission is to promote Natixis’s economic research to clients in North America. In addition, he will continue to head the Research department’s global macro team and manage... More
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The economy, Stupid!
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  • Fiscal Cliff: Uncertainty Shock Or Scapegoat? 0 comments
    Nov 2, 2012 3:35 PM

    Fiscal Cliff: Uncertainty Shock or Scapegoat?

    The real debate on the fiscal cliff is not likely to begin until mid-November (or later, depending on how contentious the election is and if it requires a recount). In the meantime, businesses, particularly those in government-related industries, will be worrying about the potential changes that will take place that will affect the business cycle (hiring, investing, etc.).

    The fiscal cliff, which includes major changes to taxes, healthcare, government expenditures (mandatory and discretionary) and defense through expiring tax cuts and automatic spending cuts arriving on January 1, 2013, is already supposed to be weighing heavily on the economy.

    Broad uncertainty is counter-cyclical: it tends to increase "naturally" during recessions, but is slow to recover. However, uncertainty has different features, and political uncertainty such as red tape and government regulation seem to be the biggest problems for small business owners.

    The problem is: red tape, regulation, and administrative hurdles have been cited as factors hindering investment decisions for years. This may be why the investment-to-GDP failed to reached its previous peak when the profit-to-GDP ratio reached a historical high. This may also be why liquid assets make up more than 130% of total investment in the US. The fiscal cliff would amplify a political uncertainty that has hindered capital accumulation over the years.

    There are two questions that must be answered:

    i. What is the impact of uncertainty on the economy, (even more difficult since quantifying uncertainty is exceptionally complicated)?

    ii. What kind of change in the political landscape would be required for political uncertainty to wane?

    IMPACT:

    Uncertainty is not the same as risk. Risk relates to probability, and uncertainty relates to waiting-and-seeing. Political uncertainty is generally higher when economic conditions are bad. When the economy weakens, the risk of time-inconsistency increases. In other words, economic institutions (Federal Reserve, Federal Government) may change their (implicit) rule-based behavior. In their endeavor to alleviate economic pain or financial risk, they increase political uncertainty.

    The most widely used indicator of "economic policy uncertainty" is given by Baker, Bloom and Davis (http://faculty.chicagobooth.edu/steven.davis/pdf/PolicyUncertainty.pdf ): paper/news coverage ; federal tax code provisions set to expire / disagreement among economists: "policy uncertainty shock equal in size to actual increase in the index value from 2006 to 2011 foreshadows drops in private investment of 13 percent within 3 quarters, industrial production drops of 4 percent after 16 months, and aggregate employment reductions of 2.5 million within two years."

    Those are examples that show how uncertainty kills the "animal spirit" of entrepreneurs. Joseph Schumpeter, the man behind the creative destruction, wrote in Capitalism, Socialism and Democracy:

    The subnormal recovery to 1935, the subnormal prosperity to 1937 and the slump after that are easily accounted for by the difficulties incident to the adaptation to a new fiscal policy, new labor legislation and a general change in the attitude of government to private enterprise all of which can . . . be distinguished from the working of the productive apparatus as such.

    What is true for the economy is also true for asset prices. Standard and Poor's motivated its US Debt Rating downgrade on "uncertainty over the political policymaking process. There is no doubt that greater political uncertainty should increase risk premiums. But to what extent.

    Uncertainty definitively hinders growth. Quantifying the impact is not easy, but the outcome is clearly negative on GDP. What kind of incentive would lead businesses to invest more?

    The distribution of income is skewed towards profits. If businesses do not invest, excessive saving cripples the recovery. This explains why the Great Recession turned into a Great Stagnation, rather than a Great Recovery.

    CURE:

    There is no doubt that fiscal/regulatory transparency and visibility would lower uncertainty.

    Take, for instance, the fiscal cliff. My view is that the cliff will take place, but only in part (1-1.5% hit to GDP), and the architecture of the laws that expire or go into effect will depend heavily on who is elected into office and into Congress. For now, the likely scenario is another Grand Bargain-type change to the sequester, an extension of the Bush tax cuts (at least for families earning under $250K annually), an expiration of the payroll tax holiday and the unemployment benefits, and the maintenance of the PPACA.

    The best outcome, regardless of the president, would be to have the same party majority in the Senate and the House, which would enable for greater collective bargaining power, and less gridlock as we have seen over the past two years with a divided Congress. A very unlikely issue.

    But things are not as simple as that. There is major confusion between political uncertainty and regulation policy. For many, regulation (Dodd-Frank, PPACA, environmental policy) means uncertainty. In addition, some actions taken by the Fed to reduce uncertainty shocks (the "Greenspan Put" or Bernanke's QEs) are now likely to bring more uncertainty about the future (inflation risk).

    Yet. One may wonder why the US economy is more resilient to oil shocks than before? Some analysts hypothesize that it comes from the energy independence provided by the 1m/b/d of crude oil produced since 2005 (a reason to drill further?). As long as US gasoline prices are indexed to Brent (not WTI or Bakken oil), this is not true. The fact is that CAFE requirements have increased the efficiency of cars (chart left). As a result, there is a disconnect (chart right) between gasoline prices and the share of energy consumption in US Households' disposable income (lower nat gas prices may have helped too…).

    (click to enlarge)

    Of course, many of the new regulation have created new hurdles for companies. The fact that red tape remains the "biggest problem" for small business should not be overlooked. But repealing regulation is not always a prerequisite for stronger GDP growth or efficiency. Visibility is also necessary.

    The fiscal cliff is another brick on the pile of regulations and political uncertainties. There is no doubt that more transparency and visibility would improve the investment backdrop for companies that are far from cash-stripped. A first step would be a better equilibrium between Congress and the President. The era of "gridlock is good for stocks" is over. But there is also a high probability that the fiscal cliff is used as a scapegoat, which is the real danger for the US economy. The Great Stagnation is not just about the Fed or the government actions, but the failure of businesses to grow organically.

    For investors, the first step is next Tuesday: a divided Senate would mean further uncertainty, whoever wins. A reason to be short stocks.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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