We have been discussing with clients and friends for quite some time what might happen come January 1st if the Congress and the President cannot come to some fiscal agreement. As a recap, sequestration is the term used to describe the combination of tax increases and spending cuts that is more broadly referred to as the “Fiscal Cliff.” It is a situation of government’s own making when they could not come to any fiscal agreements prior to the election. It is a situation referred to in Europe as austerity and the strong austerity measures taken in Europe have pushed that economy back into recession, so the first part of the answer is that sequestration will likely push our tepid US economy back into recession.
The second part of the answer is that while it is not a cliff at all, but more of a steep slope, the reaction of the markets and the economy likely will unfold over the first three months of new year. The worst-case scenario I’m going outline assumes that Congress and the President are unable to agree even on partial or temporary measures to avert full sequestration. On the revenue side the payroll tax holiday will end, the Bush-era tax cuts for all tax brackets will expire, and the Alternative Minimum Tax (AMT) threshold will drop significantly. Collectively these measures are worth $320 billion ($120, $110, and $90 billion, respectively). The large and abrupt nature of these tax increases will be a significant financial and psychological shock across a broad spectrum of US households that will cause a sharp drop in disposable income, consumer and business confidence, and private consumption. This reduction in spending alone will be enough to push the economy into recession, and piling on another $200 billion plus in government spending cuts will exacerbate that scenario. The cumulative $600 billion plus impact of sequestration will prove insurmountable for the economy given the slow growth we’ve been experiencing. If that’s not bad enough, another significant piece of the puzzle is the debt limit ceiling, which comes back into play in February 2013, and raises the prospect of another showdown like the one in the summer of 2011. Another debt ceiling standoff could result in a number of negative consequences, including another credit rating downgrade, a possible government shutdown, delayed payments of government contracts, wages, social benefits, and/or late debt service payments.
Under this worst-case scenario GDP would likely contract by -2% in the first 6 months of the year, and unemployment would rise by 1%. We expect that the deterioration in the economic data and the accompanying declining markets would cause both parties to speed up a compromise, much as happened with the TARP vote in 2008. This compromise would likely include some tax relief and economic stimulus, thus, the upside to this downside scenario is that the second half of the year would likely see accelerated growth, but the net result for the year would be flat with little change in employment.