The opening act of the Fiscal Cliff Circus is now underway!
Both sides have staked out their starting negotiating positions. As I've written in the past, a deal will eventually be struck. For investors, analyzing its economic impact requires an understanding of the effect of fiscal policy.
When taxes are collected, it obviously means money is taken from one party and passed along to another. Government acts as a financial conduit that expresses the will of society's collective values. A central question indirectly answered by elections is who will pay and who will receive. From a short-term economic standpoint, however, all that really matters is the change in the rate of taxes flowing from the economy relative to the change in the rate of spending flowing back out to the economy.
When government cuts spending or raises taxes to attack the deficit, the effect is to reduce the net flow of money into the economy. This is precisely why short-term economic activity initially slows under austerity measures. Unless forced by financial markets, it explains why few governments respond to economic weakness by adopting budget austerity. Unlike a typical household in financial distress, governments respond to recessions by doing just the opposite of what people intuitively believe is prudent; they increase spending, cut taxes or do both at the same time.
If raising taxes and cutting spending are unwise economic policies in the short-term, it leaves borrowing as the remaining tool to stimulate the economy during rough times. Fortunately, the U.S. government today is able to borrow money at all-time low interest rates. Sophisticated investors appear to understand that controlling a printing press makes the U.S. completely unlike Greece and Spain. How long will such calm last? Certainly enough time to craft constructive long-term fiscal policies rather than adopt destructive policies that perversely invite the very economic troubles we seek to avoid.
Most level-headed economic advisers are counseling our politicians to make the tough, necessary adjustments to our long-term spending and tax policies while simultaneously promoting short-term policies designed to avert another recession. These advisers feel, and the evidence shows, that the U.S. still has enough time to prove to investors that we are on a healthier long-term fiscal path.
Unfortunately, it appears many elected officials are unwilling to fight the political winds blowing in the direction of deeper austerity. Their misguided intuition about government finance could lead us astray. As the Fiscal Cliff Circus unfolds, we shall see which approach ultimately wins out. If an abrupt shift toward austerity is chosen, investors should expect a predictable outcome: a slower economy along with weaker and more volatile markets.
Jason P. Tank is a Chartered Financial Analyst and co-owner of Front Street Wealth Management, a fee-only wealth advisory firm located in Traverse City. He encourages questions and comments about future columns. Contact him at 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com.