Monday, October 1, 2012

On the Cliff


Absent some earth shaking event between now and November, Obama is going to win, the House will remain in the hands of the Republicans and the Senate will continue to be equally divided. The war between Reds and Blues will be just as bad as it was a year ago. The day after the election, the fight over the fiscal cliff will commence. I expect it will be ugly.


-I think there is zero probability that all of the issues now on the cliff will be pushed off to some future period. (Ultimate-can-kicking) Some of the cutbacks/tax increases that are now scheduled, will happen.


-I put the odds on falling off the cliff without any compromises at 40%. This scenario comes about if the Reps and Dems can’t agree on anything. If that is the case, we fall very hard on January 2. (No-can-kicking)


-Therefore, I see a 60% chance of a compromise that softens the consequences of the fiscal cliff, but does not eliminate it entirely. (Semi-can-kicking, but still kicking ourselves in the face)


If there is to be a compromise, it will be interesting to see who gets what, and who gives up what. It might play out with the following results:


I)              The 2% reduction in FICA taxes is history. As of 1/1/13 every worker is getting hit with a 2% tax increase. This is a very regressive tax increase.



II)            The Bush tax cuts for those making more than $250k are gone. This is a very Progressive tax increase.


III)          The Bush tax cuts for those making less than $250k will be retained. This “centrist” compromises is the result of the “give” on #s I and II. Both sides will be able to claim that they did their best for “Middle Class Workers”.


IV)          The Alternative Minimum Tax will be adjusted for inflation and will be fully phased in over a period of three years. This tax will hit 40m taxpayers (up from only 4m today). This is most definitely a middle class tax increase.


V)            The capital gains tax rate is going to go up to at least 25%.



The result of I – V is that everyone who works, or has investment income is going to be paying more. No one will escape higher taxes.


Then there is the spending side of the ledger. The so-called, “sequestered” amounts. Here is where the real horse-trading will happen. Keep in mind that the timing of this critical argument debate will be in November and December. What else will be happening in those months that will influence the budget compromises? Talk of War.


It is almost certain that post the election, Iran is going to be front and center. Israel has promised to hold off on an attack of Iranian nuke facilities until after America votes. After November 6, the headlines will be about war. There will be big NATO/US Navy activity all over the Straits of Hormuz. This will shape the debate on military cutbacks.


With this as a backdrop, I don’t see the mandatory cuts for the military sticking. Most of the promised cutbacks will get eliminated, or pushed forward. Obama would welcome this, as it would allow him to trade more military spending for a deferral of the cuts in non-defense spending.

We will get a half loaf of spending cuts and increased taxes. The results will not significantly change the trajectory of the deficit, it will create an additional drag on the economy.


If all of the tax increases/spending cuts now pending are allowed to happen (we fall off the cliff) it will result in a drop in economic activity of at least 1.5%. It will bring about a recession that will last a minimum of six-months. The compromises that I outline above will still result in a contraction of economic activity. If we get (more or less) of what I see coming, then ¾% of annual GDP will be lost; for a long time.


What does a lousy ¾% mean? It means sub-stall speed. It means GDP will be well below 2% for 2013 and beyond. It could mean that growth falls below 1%. (Functional recession; unemployment up, tax receipts down)



There are two issues related to the “cliff” that are of interest to me. These are  minor matters (in the scheme of things). They are Wall Street related. They go by the odd names of:






Grant Anticipation Revenue Vehicle (GARVEE) bonds are tax free, issued by states and are backed by anticipated future revenues from D.C. for dedicated highway construction. The Fed backing (not a guarantee) makes these bonds trade rich relative to straight state debt.


The federal money to pay Garvee bondholders is at risk. Future payments from Washington are part of the sequestered amounts that will be on the negotiating table come November 7.



The rating agencies have been downgrading Garvees because of the risk of repayment. There is only $10B of Garvee bonds outstanding. I think this problem will be patched up (it’s too small a matter to cause muni defaults). I also think that there will be no more Garvees issued. The fiscal cliff showed the flaw in the construction of these “bullet proof” bonds.


Build America Bonds are taxable state debt issues. This hybrid security was a child of the crisis of 2008. It died in 2010 after $180B of BABs were issued. Republicans hated BABs, Democrats (led by Tim Geithner) loved BABS.


There is an odd feature to BABs; they become callable if sequestration takes place:



BABs were issued in the terrible days of 2009/10. Recall that the likes of Meredith Whitney were calling for massive muni defaults back then. As a result, the $181b of BABS that were issued all had nice fat coupons on them. The States would love to call that paper at par; they could replace it with much cheaper debt today. The losers would be the bondholders. They would see their nice yielding bonds called away. No one cares about bondholders anymore, so BABS are dead.


Garvees and BABS are inventions of Wall Street. They are structured financial transactions that allow states to borrow more money by accessing different investor bases (tax vs tax exempt). In the end, Garvees and BABS will be throwaways in the horse trading. Their loss does not add up to much.  However, if you are thinking that the solution to America’s economic problem is a major infrastructure build out, forget it.


A program big enough to create a few million jobs and modernize our roads, bridges, seaports and airports can’t be done with more federal borrowing. It has to come from the states. Shutting down BABs and Garvees is also saying “no” to that infrastructure plan.


The worst case outcome would be that there are no compromises; and we fall off a fifty-foot cliff, and die. The best case is that we fall off a twenty-five foot cliff, and only suffer a few broken bones and a concussion. Options that were once available to the country to dig out of an economic hole will have been lost. A long period of economic mediocrity is the most likely outcome.





  1. Bruce, quite a few of the BABs have a make whole call if they lose the subsidy payment. The 2 issues that I am familiar with state a NPV calculation using yield of commiserate tsy +100 bps. that’s a lower yield than they are currently trading at, so if they got called, owners would receive a premium to current trading price.

  2. Below is another alternative and it stinks!!!!!!

    Beware the VAT
    The infamous bank robber Willie Sutton was once asked, “Why do you rob banks?” He replied, “Because that is where the money is.” Consider this. The Bush tax cuts reduced taxes by about $300 billion per year. Letting the Bush tax cuts for the “wealthy” expire would raise only about $70 billion per year. Although “taxing the rich” is a powerful political sound bite, Progressives know it is no solution at all.
    Despite, denials by Progressives, we are headed toward a financial crisis of epic proportions. Almost everyone understands that trillion dollar a year deficits, a $16 trillion debt and borrowing $.40 of every dollar spent are a recipe for disaster. Yet, Progressives in the Senate and the President have not put forth any meaningful plan to address our financial problems. So, what is the Progressive end game? In an interview on CNBC, President Obama would not rule out a Value Added Tax (VAT) saying that he “wants to get a better picture of what our options are.” In 2009, Nancy Pelosi floated the idea of a VAT as part of a comprehensive tax reform. Why a VAT? Because that is where the money is! VAT is essentially a sales tax that is opaque to the consumer. Gross receipts from a 10% VAT would be about $700 billion per year. Voila, problem solved. The VAT is a staple in Europe. Most have VAT rates of about 20% (note: When the VAT was first introduced in Europe in the 1960s it was “only” 5%).
    It is obvious to anyone, Progressive politicians included, that a VAT would be universally unpopular. Who wants to pay 10-20% more for every purchase? The unintended consequences of massive tax increases are higher unemployment and slower economic growth. By failing to address our spending problems now, Progressives will propose a VAT as the only solution to the next financial crisis. Conservatives have more prudent ideas. Address the problems of spending, entitlements, tax and regulatory policy now so a crisis can be avoided. Think about this as you cast your ballot.

  3. Bruce –

    I believe there’s a hike in the dividend tax rate to 44.8%. This may be changed due to pressure from the house, or it may only apply to those making > $250K (this is irrelevant as this group comprises most of the people with big dividend income). However, if anything like this rate goes in I think it creates a huge change, i.e. companies no longer issue dividends and instead hoard cash and/or increase buybacks. Needless to say, hoarding cash is not helpful as yet more institutions will hang around with large war chests and money velocity will drop further. Can you comment?


  4. Bruce,
    Great writing as usual. Why haven’t you given up on the debt-enslaved robots yet?
    Seriously! I bought my first gold coin in 1999 at $289/OZ, paid off my house in 2010, and told my clients to stop investing because the USA empire is coming to a close. For 15 years I have watched, pleaded, begged, and informed anyone who would listen…….and yet in one month, the majority will vote romney/obama and wonder why nothing changes in their life. They have been dumbed-down, fattened-up, and are ready for slaughter. Yet, most people still don’t want to talk to me about the USA’s problems.

    As time has passed, I find myself siding with the illuminati. (Maybe their plan of “500 million” makes sense because the earth’s resources are limited and with such ignorance out there, why prolong the inevitable?) Also, if you can’t beat them, joint them.

    These robots will never understand the Bretton Woods Agreement of 1948, what it means to have a monopoly on other currencies becasue we are the “reserve” currency, or for that matter: history!
    Ask yourself this: do you think the slave owners would teach the slaves to free themselves?
    Obviously, the politicians will never tell the citizens how to free themselves!

    So my question remains: Why haven’t you given up? I have and it feels great. No more circular logic, no more round and round with the left/right paradigm, no more ignorant statements like “lesser of two evils”. I moved my family to a town where no one knows us, no one bothers us, and when asked, I state my career is being a stay at home dad. Even though I manage money, no one cares anymore.
    Go to a starbucks and walk in and ask if anyone would like to talk about IRA’s, 401k’s, or stocks? LOL.
    It’s over and the fact that you keep trying to help is nice, but detrimental to your health.

    Besides, you are only preaching to the choir at this point in time.
    Pull a John Galt, ditch, and this will speed up the decline. IMO, your efforts to educate are slowing it down much like the Fed’s ZIRP…..atttempts to help only end up to hurt.
    Seriously, if it has taken 15 years for myself, zerohedge, and you to only wake up 15% of the people…….why are you waiting for 2040 for the rest to catch up? it will be too late then.

  5. Shouldn’t we mention the biggest revenue source in the country? The richest counties in the USA are the ones surrounding Washington DC.

    Firms like SAIC and Booze Allen are running “consulting” gigs for the government at 4-5 times what the already overpaid bureaucrats get paid.

    Boeing and General Dynamics have expanded from pure military contractors and now handle more than half the workload of things like Medicare — taxpayers are paying expensive contractors AND paying expensive bureaucrats. Both the bureaucrats and the contractors get pensions and real healthcare (not Obamacare) in addition to pay levels much higher than the private sector

    And lets talk about the bang-up job that all these new intelligence services did in heading off the terrorist attack in Libya…. the incompetence was almost as bad as the financial regulators who were watching Government Sachs, Merril, JP Morgan, Citi, Countrywide, Wachovia, etc. A movie no one ever heard of set off an embassy attack, and the subprime contagion is well contained!

    Q: What sort of spineless losers would accept this level of failure? and then pay extra for it?
    A: the taxpaying citizens of the USA!

  6. Sorry but Obama will not win the election so rewrite your comments

    • Jim,MtnViewCA,USA says:

      Robert, I’m with you.
      But everyone who depends on the MSM for news has been told that the election is a mere formality.
      States like Ohio and Wisconsin which have recently elected Repubs as Governers and are majority Repub in their state legislatures are polled to be overwhelmingly for Obama. States which went for Obama by +5 in 2008 are being weighed as being +8 or +10 or more Dem for the purposes of 2012.
      This will be an interesting election,
      Here’s a bit of news for those open to other viewpoints.

    • If Romney wins, is he going to become Neutron Mitt? Gut the bureaucrat headcount and leave the dozens of massive new buildings that went up all around DC? Cut the pay level of government “workers” down to private sector levels? End their pension scams that no one in the real world gets?

      Is Romney going to do any of that? Or will he make all sorts of promises and then kick the can further down the road?

      Maybe Ryan might (if he is being honest in his speeches) … but Romney and Obama are both part of the status quo. Either Washington DC gets gutted, or the rest of the country gets gutted. Neither candidate is talking anything beyond a few cosmetic changes in DC

      • Jim,MtnViewCA,USA says:

        A huge difference is the compliant press.
        I think you will be astonished at the spread of fascism/statism in a second Obama term. The media is letting a lot of stuff go by that they would call out for a Repub president.
        But November and beyond will tell the tale.

  7. In the options you listed for increasing revenue, you did not mentioned removing the cap on FICA tax. Currently, an individual does not have to pay FICA on annual earnings above $106,800. Removing that cap and having all earnings taxed at the FICA rate would be a progressive tax increase AND would take care of about 80 percent of the projected Social Security revenue shortfall that’s due to arrive over the next several decades.

    • Pima Canyon:
      What percentage of the increased payroll tax dollars would be going into the trust fund (the surplus FICA dollars go into the trust fund). And, of that amount, how much would be interest credited to the fund?
      Both these numbers (and percentages) would be avaialable to pay for benefits through raising new general revenues – the same way we pay all pay-as-you-go expenses, such as Medicaid and defense.
      Don Levit

  8. It’s all overblown. The Republicans are already sweating profusely over defense cuts and the last thing the Dems want is to be soft on defense. An Obama victory means the Rs will have to surrender on the small tax increases on the top earners in return for keeping the spigot flowing for defense. The limit will be increased to something like $1 million instead of 250K and capital gains will only be about 20%.

    Maintaining levels below $250K to $1 million will be a layup. There will be much sound and fury over almost nothing.

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