Economic Commentary - October 2012 

By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company

The Fiscal Cliff Cometh

More than 100 years ago, the last of the financial panics that wracked the U.S. economy throughout the 19th century and into the 20th century was underway. The Panic of 1907 was the last and most severe of these financial panics and the one that finally inspired the government to begin instituting banking reforms, including the creation of the Federal Reserve System.

In the days before the advent of deposit insurance, consumers had no assurance that their funds would be safe in a bank. If there was any hint of financial instability with a specific bank or the overall economy or stock market, depositors were likely to get nervous, which could result in a run on a bank or banks. Depositors would line up outside of a financial institution, rumors would spread, the lines would grow and eventually the bank could actually run out of money and close. In that event, anyone who hadn’t gotten a hold of their funds was simply out of luck.

The Panic of 1907 was itself sparked by a failed run on copper by Augustus Heinze, exposing an interlocked and corrupt system among New York City banking, trust and financial firms. As the panic spread, the banking system faltered, and banking titans, including J.P. Morgan – founder of the institution now known as JPMorgan Chase – met to try to stem the panic. It took a united effort on behalf of bankers, the media and the clergy as well as an injection of cash into the banking system, but the panic eventually stilled and calm returned to the financial markets.

The fiscal cliff that the U.S. government is facing in January is very different than the Panic of 1907, yet there are some similarities worth noting. One of the most striking similarities is how a lack of confidence can undermine a financial system. While the lack of confidence in the system in 1907 was seemingly more well founded than the lack of confidence in the U.S. government’s commitment to resolve the fiscal cliff crisis today, the fact is that if a solution to the fiscal cliff dilemma isn’t found, it could undermine the U.S. economy and cause a recession, although a panic like the one that occurred more than 100 years ago is extremely unlikely.

In this month’s commentary, we’ll explore the fiscal cliff as well as the specifics behind the tax and spending cuts involved. We’ll also discuss the potential economic impact and the background for this issue, the ultimate resolution of which will likely determine whether the U.S. economy continues its fragile, stop-and-go recovery or slides back into recession.

Fiscal Cliff ABCs

The seeds of the U.S. fiscal cliff dilemma were sown by two separate events. The first is the impending expiration of the Bush tax cuts, which were originally set to expire in 2010 but were extended by Congress and President Obama. The second is the government shutdown drama that occurred last August when Republicans and Democrats couldn’t agree on a debt ceiling extension and nearly caused the federal government to run out of money and be temporarily unable to pay its bills.

To raise the debt ceiling, Congress and the president agreed on a package of spending cuts that would take effect this coming January if other measures weren’t taken in order to deal with the deficit. The confluence of these two events is what created the fiscal cliff.

Spending Cut Details

In mid-September, the White House released a comprehensive list of the spending cuts that would be required should the budget cuts agreed upon by Congress and the president fail to be averted. These would hit a wide variety of departments, with the cuts of $110 billion in 2013 divided between domestic programs and defense programs. In all, the spending cuts are scheduled to total $1.2 trillion over a 10-year period.

This was the compromise that Congress and the president agreed upon as a fallback if there was no subsequent agreement regarding a 10-year budget deficit-cutting package last year. There wasn’t, and now these cuts are scheduled to take place on Jan. 2, 2013.

Basically, the cuts boil down to $55 billion from the defense budget and $55 billion from non-defense spending. The defense spending must come from discretionary defense spending; that is, defense spending that is not war-related. Military personnel spending can also be exempted. What’s left will be subject to across-the-board cuts. In practice, these cuts will translate into a 7.5 percent cut in non-affected defense spending.

As for non-defense spending, most non-defense discretionary programs will be subject to an 8.4 percent cut. Non-defense mandatory programs other than Medicare will be subject to an 8 percent cut, and there will be a 2 percent cut in Medicare provider payments. A number of mandatory programs are exempt from cuts, including Social Security, Medicaid, the Children’s Health Insurance Program (CHIP), SNAP (formerly known as food stamps), Supplemental Security Income, veterans’ compensation and federal retirement.

Tax Increase Details

A number of tax increases – also known as revenue increasers – are set to take effect at year’s end when previous tax cuts or breaks expire. The largest among these are the Bush tax cuts, a collective term for a group of tax cuts that took effect in 2001 and 2003. Here’s an overview:

Economic Implications

The Congressional Budget Office (CBO) conducted a detailed study of the fiscal cliff and its implications for the U.S. economy. The bottom line is scary: the CBO estimates that if nothing is done to avert the fiscal cliff and all the tax increases and budget cuts go through as planned, $487 billion in budget cuts will occur in 2013, resulting in a 3.1 percent reduction in gross domestic product (GDP).

That doesn’t mean that the economy will contract by that amount. It means that this amount will potentially be deducted from economic growth that would likely occur at that time, actually resulting in an overall economic contraction – a recession, essentially – of 0.5 percent. The CBO’s projections have been getting more negative as the year has progressed. Initially, they projected an actual 0.5 percent GDP gain for the year but revised that down recently due to what they now believe will be a more significant drag on economic growth. Couple this with what the CBO sees as a significant rise in the unemployment rate by the fourth quarter of 2013 – up to 9.1 percent from the current 8.1 percent – and there is little chance, if these cuts and tax increases are implemented, in avoiding a recession that will have a significant impact on businesses and consumers.

Since no one knows how this situation will ultimately be resolved – whether through full implementation of the cuts and tax increases, some kind of middle ground solution or full repeal of the budget cuts and an extension of the Bush tax cuts – the CBO has also worked up some projections about what a middle ground might look like. Under this scenario, most of the expiring tax cuts are extended and some of the budget cuts are repealed. While the ultimate impact on the economy would be softened versus no action, the economy would still grow at an anemic pace of 1.7 percent in 2013 with an unemployment rate about where it is now.

While this outcome is certainly preferable to a recession, it underscores just how fragile the current economy is. For many businesses and consumers, even this preferred outcome won’t bring much joy and will continue to feel more like a recession than a true recovery. That’s because there are too many factors outside of the fiscal cliff inhibiting economic growth for the resolution of this one issue to make a gigantic difference and help the economy experience true, sustainable growth. To really bring unemployment down and get businesses and consumers spending again, the economy needs to grow at about a 3 percent rate.

Add to these problems the fact that we could replay the debt ceiling drama early in 2013: the debt ceiling is currently capped at $16.394 trillion, and experts say the government is likely to approach this ceiling in early 2013. Not only could this fuel an already combustible situation around the fiscal cliff, but another protracted debate could also roil markets. The last debt ceiling debate raised the cost of U.S. government borrowing by $1.3 billion in 2011 according to the Government Accountability Office.

A Final Word

While it’s extremely unlikely that a lack of resolution surrounding the fiscal cliff will spark the type of financial panic that occurred in 1907, this isn’t a minor issue. Without a resolution, it’s extremely likely that the economy will roll back into a recession, negatively affecting business owners and consumers as well as the markets. In addition, continual uncertainty and lack of confidence in the U.S. government’s ability to manage the economy in a responsible manner and bring about some type of economic growth and fiscal restraint is a big negative.

If government and fiscal paralysis and irresponsibility continue long enough, they will further damage the credibility of the U.S. government and, by extension, the U.S. financial markets. Ultimately, that credibility gap may result in further credit downgrades, a further shift in economic and political power to rising powers such as China, Russia, Brazil and India, and a further decline in the economic prospects and clout of the middle class, one of the true backbones of the U.S. economy.

Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Bond or debt investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Greater risk is inherent in investing primarily in high yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility. There is an inverse relationship between interest rates and bond prices. Government debts are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest when held to maturity.

Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. All index references and performance calculations are based on information provided through Bloomberg, a provider of real-time and archived financial and market data, pricing, trading, analytics, and news.

The Congressional Budget Office (CBO) is a federal agency within the legislative branch of the United States government that provides economic data to Congress. The CBO was created as a nonpartisan agency by the Congressional Budget and Impoundment Control Act of 1974.

The U.S. Government Accountability Office (GAO) is an independent, nonpartisan agency that works for Congress. Often called the "congressional watchdog," GAO investigates how the federal government spends taxpayer dollars.

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