OK, tomorrow is not the end of the world after all. It looks like we have a deal (a bad deal, but a deal nonetheless). While the details are not all available yet, here is the broad outline.
It is a two-stage process. First there will be $900 billion in spending cuts over the next ten years. I have not seen exactly where those cuts are coming from, nor how front-end or back-end loaded they are. Then a “super committee” made up of members of both houses will have to come up with an additional $1.5 Trillion of deficit reduction (could be spending cuts or tax increases in theory, or any combination of both) by the end of the year, and Congress will have to go along with what the committee comes up with.
If they don’t, then automatically an additional $1.2 Trillion of spending cuts kick in. Those will be half from the Defense side, and half from non-defense. The non-defense side will not include any cuts to Social Security or Medicaid. There could be cuts to Medicare, but they would fall on the providers, not the beneficiaries.
This compromise — no, make that capitulation — on the part of President Obama and the Democrats will result in a slower economy than we would have otherwise had. How much slower depends on how front-end loaded the cuts are. My guess is about 0.3 to 0.4% lower growth in 2012 that we would have otherwise had, and unemployment higher by 0.2 to 0.3%.
Economic growth has already been pathetic in the first half (see “Read ‘Em & Weep: GDP in Depth”), in large part because government spending has already been slowing down dramatically, but mostly at the State and Local level. Now there is going to be a serious slowdown at the Federal level as well.
It is pretty clear that there will be no more extension of unemployment benefits after the extended cuts run out in December, despite over 6 million workers (many more if you count their families) who have been out of work for more than six month (i.e. their normal unemployment benefits have run out), or almost half of all the unemployed. The cut in the payroll tax will probably not be extended, meaning that the average worker will have about $1,000 less in take-home pay in 2012 than he or she had in 2011.
Those payroll taxes will be the only taxes that go up, the ones that hit the very first dollar of income, but which no longer apply to income over $106,000. Of course that is only earned income; if you get most of your income in dividends and capital gains, you still only pay a 15% tax rate. There will be no additional spending on infrastructure or clean energy development.
I suspect that since there are no automatic tax increases under the “no agreement in the super committee scenario” that the Tea Party wing of the GOP will again hold out and when all is said and done, virtually all of the $1.5 Trillion in second-stage deficit reduction will come from spending cuts, or the automatic cuts will end up going into effect. Obama has caved repeatedly, in December when the Bush Tax cuts were set to expire, when there was a possibility of a government shutdown in the Spring, and now once again. Many of the rank and file Tea Partiers will be hurt by this deal, but the big-money types that back them will not be.
I have used the analogy of the Cuban Missile Crisis before. Well, the world did not end this time, just like it didn’t back in 1962. The difference, however, is that Cuba is still bristling with missiles. The compromise was that the USSR had to limit the range of the missiles to 2000 miles, so the West Coast, Alaska and Hawaii were safe from the threat. Still better than WWIII, but not a good situation.
We will probably see a relief rally in the markets today, and we might regain about half of what we lost last week by Friday. That does not mean this is a good thing for the economy. There is no such thing as expansionary austerity. I’m not even sure that the spending cuts are going to be all that effective in bringing down the deficit, the supposed point of this exercise.
The slower economy is simply going to result in lower tax revenues. So the initial $900 billion in spending cuts will probably result in no more than $500 billion of actual deficit reduction. On the other hand, the world will not end tomorrow.
Zacks Investment Research
