The Grand Fiscal Cliff Compromise; Official Holiday Party Discussion Cheat Sheet

ForexTV   |  November 10 2012 3:10 EST

ForexTV.com (New York) by Timothy Kelly

President Obama held a press conference on Friday to address the debt crisis.  Adorned by a backdrop of ethnically diverse individuals, President Obama came out swinging in the so-called "fiscal cliff" battle with the equivalent of a velvet hammer on Friday.  Mr. Obama, armed with a fresh term seemed upbeat and ready to cooperate with Republicans.  In his first public appearance since re-election, the President clearly was not resting on his laurels.  His press conference was well choreographed in style and substance and his message was one of compromise and centrist inclination.

After two widely publicized press conferences by House Speaker John Boehner, where the Speaker was clearly positioning ahead of the fiscal cliff debate, the President came out as expected with a brief message, striking a cooperative, yet decisive tone and seeming very centrist in his approach.  However, the President made it clear that a tax increase on upper income earners was an administration priority.

Both Sides Claim Voter Mandates

The President all but claimed that his re-election represented a mandate by the American people to raise taxes saying, "the majority of Americans agree with my approach."  In fact the popular vote was virtually split with only a 1.2% margin between Mr. Obama and Mr. Romney.  Out of an estimated 228,000,000  voters, only 53.2% of eligible voters voted: 27.2% Obama 26% Romney.  While statistically a majority, it falls short of a mandate.

On the other side, Mr. Boehner argues that voters handed Republicans a mandate, actually increasing the Republican Majority in the House of Representative.  Like Mr. Obama, claims of a mandate fall short of the mark.

Mr. Obama's Legacy Rides on Reaching a Deal With Republicans

It is unlikely that the President will be able to enact any meaningful new legislation on the scale of Obamacare  in his second term with the House Majority in favor of the Republicans.  However, tackling the nation's debt crisis and fixing the economy is enough for any one man, not to mention the Senate and the House of Representatives.  And if successful, could be one of the most significant accomplishments of any President.

It is no surprise that lurking very prominently in the background of the Obama camp is former President Bill Clinton.  Mr. Clinton's political acumen, especially during his second term, may likely be the blueprint for Mr. Obama and see him make a giant leap toward the political center.  It is a leap the President must make to ensure any hope of progress and a legacy for his Presidency.

As if on cue, Mr. Obama made at least a running start at that centrist leap when referring to a possible fiscal cliff compromise with Republicans, "I'm not wedded to every detail of my plan. I'm open to compromise," said president Obama.

While Mr. Boehner also signaled a willingness to compromise, Mr. Obama is likely to have deflated the Republican argument with his statements and the political capital he earned winning re-election, even before the debate begins.  "If there is a mandate in yesterday’s results, it is a mandate for us to find a way to work together on solutions to the challenges we face together as a nation," Mr. Boehner said in contrast.
 

Political History of The Debt Debate

During the debt ceiling crisis of 2011, Mr. Obama was notably absent from the debate, allowing instead his Treasury Secretary Tim Geithner and Harry Reid to scrap it out with Mr. Boehner and the Republicans, a brilliant strategy on the part of Mr. Obama that insulated him from the fallout which was an unprecedented downgrade of America's credit rating.

In addition, Mr. Obama further removed himself from the bruising battle of 2011 by negotiating the Budget Control Act of 2011 (BCA).  The BCA was a compromise that resolved the debt ceiling crisis of 2011,  averted a default of US sovereign debt and allowed for deeper deficit spending by the Obama Administration. 

The BCA also provided  for the establishment of a bi-partisan committee  to address the issue of the nation's debt called the United States Congress Joint Select Committee on Deficit Reduction, commonly referred to as the "Super Committee".  The committee was comprised of 12 members (six republican, six democrats; three each from the House of Representatives and Senate) charged with drafting a legislative solution to the issue of debt reduction and tax reform with fast-track provisions that could be put to a Congressional vote by December of 2011.

The agreement also specified an incentive for Congress to act. If Congress failed to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress could grant a $1.2 trillion increase in the debt ceiling but this would trigger across-the-board budget spending cuts called "sequestrations". These cuts would apply to mandatory and discretionary spending in the years 2013 to 2021 and be in an amount equal to the difference between $1.2 trillion and the amount of deficit reduction enacted from the joint committee. There would be some exemptions: reductions would apply to Medicare providers, but not to Social Security, Medicaid, civil and military employee pay, or veterans.  Medicare benefits would be limited to a 2% reduction.

"Kicking The Can Down The Road"

During the critical final week of negotiations and Super Committee vote, President Obama left the country on a non-essential tour of Asia, enraging Republicans who had criticized the President of not participating fully in the difficult process, out of fear of political fallout if a deal could not be reached.  It was largely seen as a valid criticism and exemplified the expression "kicking the can down the road".  The term referred to the notion that politicians often try to ignore difficult issues hoping that they will either go away or that they can be delayed until such time that they become someone else's responsibility.

The near total absence of Presidential leadership and the establishment of the Super Committee was widely seen as a failure of the two parties to reach a compromise and a mechanism for politicians to seek political cover for their failures.  In August 2011,  just after President Obama signed the Budget Control Act into law,  the rating agency Standard & Poor's  downgraded the US credit rating from AAA to AA+ saying:

... The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges ... (we are) pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon. The outlook on the long-term rating is negative.

The New Debt Battle

Mr. Boehner knows that the Republicans made a huge tactical error in not dragging the President into the debate in 2011, and is now trying to focus the attention and responsibility squarely on Mr. Obama personally.  Boehner repeatedly addressed the President directly and personally in his press conference to take responsibility for negotiating the fiscal cliff issue saying "We're ready to be led, not as Democrats or Republicans, but as Americans. We want you to lead -- not as a liberal or a conservative, but as the President of the United States of America. "

The Republican tactic, if it is in fact political posturing, is puzzling because the dynamics have changed profoundly.  At this point, Mr. Obama has little downside political risk in fully engaging the process in that he does not have the consideration of re-election to worry about.  Thus shifting the burden of compromise to Mr. Boehner and the Republican House to avert falling off the fiscal cliff.  So in essence Mr. Boehner's tactics are akin to closing the barn doors after the horses have already run out.

If, in fact, Mr. Boehner is sincere in his desire to reach a compromise with the President, the two sides can pick up the framework of the failed Super Committee negotiations, which both sides have described as "close" to an acceptable compromise and begin to mitigate the effects of our staggering debt. 

Unlike 2011, the issue of reducing the deficit cannot be avoided much longer without further and irreversible damage to the US economy.  It is unlikely that either party will allow the US to "fall off the fiscal cliff" and default on our debt obligations and a last minute temporary fix is still a likely outcome.  However, serious consequences await the US economy should a meaningful, long-term solution continue to elude lawmakers. 

The "Plumbing" of The American Economy and the FED

Today, the Federal Reserve’s duties fall into four general areas:

•  conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates

•  supervising and regulating banking institutions to ensure the safety

and soundness of the nation’s banking and financial system and to protect the credit rights of consumers

•  maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

•  providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system

The S & P downgrade of the US credit rating in August, 2011 had little or no effect on interest rates, contrary to expectations, due to the massive infusion of stimulus capital (quantitative easing) provided by Federal Reserve Chairman Ben Bernanke and the Federal Open Market Committee Operations. 

In addition, US Treasury securities are still seen by most of the world as the safest place to invest, despite the S&P downgrade.  The demand for US Treasury securities and the Federal Reserve buying of these securities has kept US borrowing costs artificially low.  At the same time inflation remains subdued (around 2%) and has helped to anchor interest rates at present levels.  The US Treasury can now borrow at 2.74% for thirty years and .26% for two years.  The ten year borrowing costs are 1.61%. 

It is estimated that the Federal Reserve (which has a virtually unlimited credit limit) has a balance sheet of approximately $2.8 trillion as of September 2012.  The Fed has indicated that it would begin new purchases equivalent to $40 billion a month, including mortgage-backed securities in an effort to stimulate lending while keeping interest rates low.  The hope is that this stimulus would grow the economy, mainly the sluggish housing and manufacturing  sectors.

The Fed is counting on something called the (M1) Money Multiplier sometimes referred to as the velocity of money.  Basically, it tracks the effect of money injected into the economy at the top levels.  There is an expectation that as more money is injected into the economy it is expected to "multiply" as it is lent out to business and individuals, thereby increasing consumption and re-investment, expanding the economy and creating more jobs.

To date, the Fed buying programs have not had the desired effect since non-emergency buying by the Fed began several years ago.  If the current rate of Fed buying continues through 2015 as stated in the FOMC minutes, the Fed balance sheet could possibly expand to a figure close to $6 trillion.  Keep in mind the Fed balance sheet has nothing to do with the National Debt.  Lenders appear unwilling to lend, borrowing demand is subdued and as a consequence unemployment continues to rise.  Yet, the Fed presses onward. 

The Dangers of Too Much Money in the System

By keeping interest rates low, and injecting more money into the system, money is said to be "cheap" and therefore there is an expectation that businesses and consumers will have an incentive to borrow.  That is simply not happening.

To illustrate the point, picture the money supply as a lake at the top of a valley and the US economy is a village at the base of the valley.  The Fed would be the dam holding back the waters of the lake from flooding the valley below, yet allowing just the right amount of water to flow to sustain the village.  The valve used to regulate the water flow is interest rates.  The gauge of how much water to supply is the inflation rate.  When inflation rises (prices rise) the Fed will lower the flow; when inflation falls (prices decline), the Fed increases the flow. 

While the velocity of money is presently stalled, it is uncertain what is inhibiting the process; the valves simply do not appear to be operating correctly.  Continuing to add liquidity into the lake at the top at such a vigorous pace has inherent dangers according to some economists.  Once filled, the lake has nowhere to empty except in the village below.  If the dam somehow is breached, it would cascade a flood into the village below causing prices to rise rapidly resulting in hyper-inflation, thus putting enormous upward pressure on interest rates and reducing the value of the currency.

The US dollar has already begun to experience a rapid decline in value as financial markets react with near immediate effect.  Once the Fed announced its program of Quantitative Easing, the dollar began to fall against almost every major global currency.

Walking the Debt Tightrope

If the darkest fears of economist are realized, and interest rates climb even modestly (let alone drastically), America's ability to pay even the interest portion on its massive debt would become untenable.  Mopping-up close to $5 trillion in excess liquidity from the US economy would be next to impossible for the Fed without itself causing extreme shock to the economy.

American politicians have been kicking the can down the road for almost five years on the debt crisis and the current administration has added a staggering and unprecedented burden to America's debt load in the past four years.  it is only a matter of time before the dam bursts if we remain on the current course.

Forex research by ForexTV.com