Wednesday, September 5, 2012

Sailing Off the Edge of 2012: Europe, Iran, and the Fiscal Cliff’s Effect as the Biggest Tax Increase, Spending Cuts in 100 years

I remember one of the first times I saw The Weather Channel.  I thought it was neat. I waited until the ‘local weather on the 8s’ and changed the channel.  Strange business model, I thought. Who will watch it for more than 10 minutes? Then I found myself watching more and more, especially the shows about storms. I suppose it’s just human nature to be fascinated with disaster and destruction. I am particularly intrigued by the projection as the storms form in the ocean, build strength and then wreak their fury.  It’s possible we have a triad of storms for the remainder of 2012, with the ‘storm of the century’ hitting on the exact dates of December 31, 2012, and January 1, 2013.

Storm One:  Europe.  Europe is by no means a new problem, nor is it an unknown problem (Greece, for example, has been in default on its debt for the majority of the years it has been an independent country).  The problem of course, is that certain members are forced to bail out or assist other members to keep the stability of the Union.  If the EU were created today, they probably would have instituted a common currency and a common debt, instead of allowing sovereign debt amongst members.  To paraphrase John Maudlin of Millennium Wave, we have three disasters:

Disaster One:  Everyone buckles down.  The Greeks pay their taxes, the Spanish impose austerity, the Germans provide the funds, and the Union strengthens and works its problems out.  This is a long-term ‘good’ solution, and a short term painful solution.  It will probably cause a mild recession in Europe.

Disaster Two:  The EU falls apart.  The Greeks leave the EU, potentially followed by others.  The remaining members either form a ‘Euro Lite’ or go back to their Marks, Francs, Liras and Pesetas.  I think this is disastrous and would cause a serious widespread problem.  Economic output would likely fall an average of 10%, unemployment would soar and inflation would rise.

Disaster Three:  Nothing happens.  In this most likely scenario, the whole thing keeps muddling down the current path of rhetoric and band-aid solutions.  Greece keeps running out of money, the Germans keep paying it; the French tax their citizens, who protest, and so forth.  No real solution until growth lifts all the boats. Continued uncertainty in sues.

Storm Two:  Iran.  Iran is also not a new problem.  The Iranians are desperately seeking to enrich uranium to weapon-grade.  The Israelis and the US (and most of the rest of the world) are desperately trying to stop them.  The showdown is moving to the old west movies where the gunfighters are starting to walk down the street of the town.  Three potential disasters loom:

Disaster One:  Iran builds a nuke.  I would pose that a nuclear armed Iran would be unstable and dangerous under its current regime—bad economically and otherwise.

Disaster Two:  Israel (US) does a preemptive strike.  In the world’s worst-kept secret (to the extent the CIA has published a map of the targets), Israel, fully assisted by the US, hits the Iranian nuclear sites and destroys the Iranian nuclear capacity.

Disaster Three:  The AC/DC non-solution.  In July, some mysterious computer virus hit the Iranian computer system, shut down the centrifuges, and then blared the rock song ‘Thunderstruck’ by AC/DC.  It didn’t stop anything, but it slowed it down.  The idea here is keep making it expensive, keep wasting their time, and they will either give up or somebody new will take over and give it up.

The Storm of the Century:  The Cliff.  The scariest of the storms, the one that puts a gleam in the eye of the Weather Channel boys, is the monster storm forming at the end of the year.  This storm has four or possibly five ‘legs’ that form a cell of enormous magnitude.  The legs are:

  • The expiration of the Bush Tax Cuts (12/31/12), which raise taxes by an average of 17% on all taxpayers, and very adversely raise taxes on working parents and high income investors (think over 70% increase).  Tag about $285 billion in tax increases on individuals, about $75 billion on businesses, the old ugly estate tax, and you have the biggest tax increase in history.
  • The expiration of the payroll tax ‘holiday’ (12/31/12), or the 2% temporary cut in Social Security taxes.  This increases taxes another $127 billion.
  • The new UIMC tax (01/01/13) on unearned income that was added in the Affordable Care Act (ACA).  This adds a 3.8% tax on interest, dividends and capital gains on unearned income for taxpayers with income over $250,000 ($200,000 if single).  $24 billion more.
  • The Budget Sequestration Cuts (01/01/13) take a sledgehammer and immediately knock off $109 billion in Federal spending.
  • And a fifth leg, if you like it, is the expiration of the debt ceiling in or around February of 2013.

So the storm is three significant tax increases, which can cut consumption, which will cut profits, which will slow down hiring; plus federal budget cuts, which will cause unemployment, which may forestall spending; plus the government may not be able to borrow to pay its bills.  In total, the number is daunting:  about $817 billion of tax increases and cuts.  Historically, this is the biggest tax increase in absolute dollars ever.  At 5% of GDP, it’s also the biggest tax increase/spending cut in relative terms since 1942.

What’s also scary is that all of these things happen automatically:  Congress and the President must act to have them NOT happen.  Given the animosity and vitriol in Washington, a smooth solution seems unlikely.  In addition, the election is on November 6th, so it seems further unlikely anything would happen until the lame duck session.  You can game this out, but if we have a new president, the old one may not be amenable to fixing the cliff. The three scenarios again:

Disaster One:  They fix part of it.  This is a hopeful solution; they may extend most of the Bush Tax Cuts, and make some budget changes, maybe let the payroll holiday expire—storm semi-averted.

Disaster Two:  We sail off the cliff.  At least temporarily, huge tax increases (don’t get me started on AMT) and budget cuts will cut GDP, and probably change consumer behavior (a 17% increase in taxes will decrease spending).  In the longer run, the $817 billion goes farther than any of the politicians had dreamed of, raises taxes and cuts spending, pushing us closer to a balanced budget, but at the cost of a recession.  If we go off the cliff and don’t fix the cliff fast, I see the only logical outcome is a recession.

Disaster Three:  They kick the can down the road.  Somewhere right around the end of the year, like December 21st, Congress could move the expirations and effective dates out a year or two.  We can then sit on pins and needles for another couple of years.

The Weather Channel can have a field day with this.  In this case, unlike other storms, such as the subprime crisis, or even my first two Storms, we know the absolute date and time of landfall.  We can tie a cartoon of $817 billion dollars to the ball in Times Square and watch it fall with the ending of 2012.

As for me, I’d rather watch this storm from a safe harbor.  We’ve cut our equity positions 50%, and will wait out that portion in short term corporate bond funds or ETFs. 

On the other hand, the Mayan calendar indicates that the world will end on 12/21/12.  Maybe I’m worrying too much about money.