The Fiscal Cliff Looms Because Mainstream Economists Got the Strength of the Post-Crash Economy Wrong

A problem with “fiscal cliff” economic reporting is the lack of context.  It is widely said that if only the “uncertainty” of the cliff were resolved, then businesses would invest again and all shall be well.

The problem, though, is that said fiscal cliff (or, fiscal slope) is the direct result of the failure of governmental and private sector economists to forecast the subpar economic recovery.  All the projections that the severe “great” recession would be followed by a long and strong business expansion were incorrect.  (Instead, the proprietor of The Daily Capitalist and I have, unfortunately, each been much closer to the mark in our consistently more restrained assessment of the likely course of U.S. economic activity.)

The consequence of this is larger Federal deficits than projected and continuing reliance on the central bank to “support” economic activity.  The governmental decisionin 2011 to kick the deficit reduction plan down the road and hope for a stronger economic performance has also failed in the sense that only through further quantitative easing and similar Federal Reserve policies (helping to finance LTRO, Operation Twist) could the government continue to spend so much more than it takes in without pushing up interest rates and thus sustaining the housing market in specific and other credit-dependent parts of the economy in general.

Yet the Keynesians continue to twist matters around.  One example of many comes from Calculated Risk today in his update on the “cliff” negotiations (LINK):

Clearly there is going to be more austerity in the US at the Federal level next year. How much is unclear.

An opposing point of view is, of course, that there is likely to be less Federal profligacy next year.  How much is unclear.

The United States is now at a turning point.  Europe’s economic problems are being dealt with to a degree, and the euro is rising to reflect that.  Countries that the U.S. in essence laughed at in the 1980s and 1990s, such as Mexico, Russia and Brazil are outperfoming it economically.  As the custodian and printer of the global reserve currency, the U.S. must, by definition, run a trade deficit, and a declining dollar raises the cost of imports.  Thus:  price inflation, which must lead to rising interest rates over time unless productivity surges and/or credit/money creation is quite restrained.  

The Federal Government has dealt with the financial and economic crisis by taking up smoking (or, drinking, if you like) again, having broken the habit in the 1990s.  As with any habit or addiction, it cannot break it by simply doing less of it.  

After the alleged “change election” of 2010, Bloomberg News found in a national survey that people wanted fiscal austerity, but simultaneously wanted a generous set of Federally-provided benefits.  The people wanted to eat their cake while keeping it around to eat it again.

This explains the 2012 election.  The people were satisfied with putting the purse strings of the government once again in the hands of the party that says it is against taxes.  The people also gave the party that is now for higher taxes (it always starts on “the rich”) and continued Federal largesse some extra seats in the Senate and returned Mr. Obama to office.  This dichotomy is playing out in Washington.  The House Republicans indeed have a mandate, even if the Democrats have a stronger mandate.  

The United States is thus both politically and economically between a rock and a hard place.  Rely on the printing press and prices will rise, with interest rates certain to follow (unless formal interest rate and probably currency controls are instituted, which is incompatible with being the provider of the major currency in the world for very long).  Reduce the injection of Federal dollars into people’s and businesses’ pockets, and withdraw a greater portion of their income in taxes, and predictably, nominal economic activity will slow.  Keynesians will complain that doing so might precipitate a recession.  Something they have decided that it is worth high inflation to try for ever and ever to avoid a normal economic phenomenon called recession.  

Matters will break one way or another, toward continued inflation/stagflation versus more toward deflation.  Economic actors are watching, waiting, and sitting on their pocketbooks.  The same thing happened in fall 2000, when the country was transfixed by the drama of the Bush-Gore post-election battle.  A recession and market crash was judged to have begun in January 2001, but I believe that it began with the tied election.  Something similar is happening now in my opinion.  

In this context, it surprises me that positioning of investors and speculators on the futures market for the S&P 500 is maximally bullish.  The conservative “commercial hedgers” in both the full-size contract and the “e-mini” that caters more to the small traders are heavily short the market.  Similarly, regional Federal Reserve surveys continue to show a good deal more optimism for business prospects six months from now than is the case now and in the recent past (LINK to one that shows how realistic businesspeople were in the 1990s, when stocks kept rising).

Careful readers will note that while I have reported on recession-callers such as ECRI, I have made no such forecast myself.  I am now moving toward the recession camp, but that’s academic in a sense to my personal world.  What I can do as a money manager is allocate capital.  As I see it, the can-kicking is coming to an end, as to do so in the setting of what is viewed as a non-recessionary economy can only occur for a while.  I think that either we move toward an overtly inflationary, rising-rate environment with yet more bubble economic activities, which is unlikely to be good for stock prices in the longer run; or we go the route the Brits took when the Cameron administration came in, which is to say a diminution of deficits but no true austerity.  Stocks are not priced in my view to provide an attractive risk-reward given these imponderables; as in Japan in its ZIRP experience, yet another crash in prices in 2013 is now thinkable.

In contrast, both Russia and Spain have depressed stock markets, as does China.  Russia trades below book value and at 6 times trailing earnings.  Dividend payouts are on the rise there, and we in the West disdain Russia’s economy and markets.  Spain, which everyone “knew” was the great re-emerging economy five years ago, is now “known” to be a permanent disaster.  Yet the Morgan Stanley ETF for Spain (“EWP”) trades below book value and has a high dividend yield.  Its stock market has broken out with a near-vertical move.  A post on an Apple forum in which I am a moderator came yesterday from someone who lives in Spain.  He said that the people are filled with despair, and have a lot of anger at the corrupt politicians and businessmen.  I responded that that mirrors the U.S. post-Lehman and through 2009.  In other words, I was saying: Buy despair, and sell optimism when the economic cycle is mature.

As I have been saying on this blog since fall 2011, taxable accounts in the U.S. in my view are best off in tax-exempt bonds (note that I am not an investment advisor).  As with bubble-type economic activities, stock market “total returns” are a mirage.  Until one sells, all one has is a price that someone else traded at (or, two machines traded at).  The same psychology that will make the average investor sell will tend to make all the other “average” investors sell, and that sudden selling pressure produces the same sort of crash that was seen when optimism finally cracked in late July 2011 and September 2008 (inter alia).    

Thus I think that the combination of municipal bonds (disinflation-type investment), “value” foreign stocks (growth/weak dollar play), and a generous cash allocation fits with what I have said since the beginning of May 2011, when the NYSE Composite Index had just hit what has proven, 20 months later, to have been its intermediate peak (LINK):  risk off (special cases such as AAPL in its boom period this winter as exceptions which I chronicled accurately at the time).

Since Mayday 2011, the NYSE Composite Index has returned about zero, including dividends.  In contrast, gold is up, and the big winners are munis and Treasury bonds.  Since May 1, 2011, the price of the 30-year Treasury bond has risen from about 28 to about 43.  That’s about a 28% yearly annual compounded return in 20 months.  Now, how many talking heads on CNBC or Bloomberg TV have told you that fact?

The drama of the fiscal cliff represents the upshot of one of the worst bits of economic forecasting that the best and the brightest have ever engaged in.  Why should anyone think that these same people and their colleagues have now estimated the future cash flows from American businesses correctly, as reflected in the price of their equities?

Thus I continue to think different.




10 comments to The Fiscal Cliff Looms Because Mainstream Economists Got the Strength of the Post-Crash Economy Wrong

  • JB McMunn

    Agree with the above, plus I’d like to add that while the Fed’s actions have been driving people out of Treasury bonds, the dividend tax hike will drive them back.

    Left hand, may I introduce the right hand? You two should try working together.

    I can envision a scenario where fiscal cliff fears drive up Treasury yields, followed by a move back into the very same bonds once people start thinking about what yield they need from a stock to get the same after-tax income.

    And then there’s Europe and Japan still teetering, with the US being the leper with the most fingers. I don’t rule out a rush to so-called quality in T-bonds.

    So although I’ve never been much of a bond guy (much to my retrospective dismay) I still think there’s room to move. Eventually the bond market will end in tears but IMHO it will take a lot longer than people think. It usually does. If Japan can string it along for 20 years, and tiny little Greece for 3 years, what time frame do we give the US?

  • i love your articles ,but i got to disagree on this like the new article about Romney’s sons and wife talking him onto running for Pres which ofcourse he lost this is what all our so called leaders continue to do to us ( try a little something) to shut us up and muddle along (kick the can)have we watched E.U. for the last dozen years, Just like a mom who wants to placate their child without doing the hard work and unpopular of solving the problems.. Some day we are going to send some serious men or a Maggie Thatcher /Sarah Palin up there to fix this when people finally wake up and really see that the Emperor is naked..

  • Californio

    My daughter came home on Friday, we expected her today, she was laid off. No projects for the company she worked for in the foreseeable future, the company is stuttering offices in other States. Small private sector businesses are on hold and downsizing again because of the additional costs they will bear next year, discretionary projects are permanently on hold. 2013 is going to be a bad year.

    I agree totally with your view and hold the same myself.

  • [...] As I see it, the can-kicking is coming to an end, as to do so in the setting of what is viewed as a non-recessionary economy can only occur for a while. I think that either we move toward…  [...]

  • Californio

    An interesting article in the WSJ, “Push for Cheaper Credit Hits Wall ”

    The new push by the FED to lower mortgage interest rates further appears to have hit a wall and is not dropping as the FED desires.

    Catch 22

  • Californio-

    So sorry to hear about your daughter.

    My son in law is in the entertainment business in and around Party Central USA, aka Miami/South Beach. He reports that business is notably slow for DJ’s to handle New Year’s Eve parties this year, and that restaurants etc. have had to cut their premium rates from last year in order to fill up.

    The cross-currents in the U.S. leave me uncertain if there is any one trend, or rather numerous smaller but defined trends that cannot easily be encapsulated in any one term.

  • Californio


    “The cross-currents in the U.S. leave me uncertain if there is any one trend, or rather numerous smaller but defined trends that cannot easily be encapsulated in any one term.”

    I believe you are correct. My daughter will be fine, thank you, but she will probably have to leave California and park her surf board for a while. The holiday sales figures and after holiday sales will be telling.

  • steve

    “The United States is thus both politically and economically between a rock and a hard place.”

    I am very concerned about the current situation because if the US political parties don’t reach an agreement the consequences will be felt in all economic sectors. As a Canadian investor working in real estate I’ve been analyzing the possible risks in this particular sector and the outlook for 2013 is quite optimistic as far as the real estate market in Canada is concerned. However, there are certain threats that could put a halt to that positive development, one of them being inflation pressures out of the US. The mutual interconnection between the two countries is very strong so I hope the US government will do its utmost to prevent the worst from happening.