President Obama kicked the Republicans' rear ends all over the ring in the budget battle and scored an overwhelming victory. He got pretty much everything he wanted, while giving up no more than token concessions. The lopsided mismatch between increased tax revenues from upper income households and the almost total absence of spending restraint implies that achieving real deficit reduction eluded negotiators to the long-term detriment of the economy. The stock market should flourish over the next several weeks, but volatility and budget negotiations will resume soon and that will likely also bring back market volatility.
The deal struck to avert going over the fiscal cliff was reached a few hours before I expected. I thought the deal would be struck around midnight, if not a few hours later. Instead, agreement occurred just before 9 PM. (Not bad for government work.) However, this deal is far from the final word on budget matters. Bruising battles lie ahead and I expect the next fight to be even tougher. The President accepted the Republican poisoned pawn. It remains to be seen if the President can hold it or if his strategy succumbs to the blunder.
There's no doubt that President Obama got pretty much everything he wanted, including higher tax rates on the wealthiest Americans, higher tax rates on capital gains for those same wealthy Americans, and no reduction in entitlement programs, neither Social Security nor Medicare. The President fulfilled his campaign promise to get the rich to pay more and he kept all of the Bush tax cuts for everyone else. His only concessions were that he allowed $450,000 to be the definition of a wealthy American, instead of $250,000, and he agreed to make estates above $5 million tax free permanently. It was a landslide victory for the President, matching up with his landslide election victory in November.
Lack of an agreement to reduce government spending on entitlements insures that the budget deficit will not be reduced very much. While the President socked it to the rich, he failed to meaningfully deliver on deficit reduction. One estimate suggested tax increases would raise $640 billion (over 10 years) and cut spending by $15 billion. The true weakness of the Republican negotiating position is apparent in this lopsided outcome. But this outcome also suggests the President achieved a public relations success without a substantive budget accomplishment. Of course, the President campaigned that fixing the budget deficit only required the rich paying their fair share, although this was never mathematically feasible. There aren't enough rich people to tax them sufficiently to reduce the budget deficit all that much. Spending reduction was always necessary, yet the cloak of the need for compromise could have been used to produce meaningful cuts in spending. This failure could prove calamitous. So, the agreement is a severe disappointment and will come back to haunt the markets, most likely fairly soon.
The President did suggest in his press conference that deficit reduction remains unfinished business, so that more discussions lie ahead. But, his comments suggested that further progress would require more taxes on the rich and he cast himself as the defender of Social Security and Medicare, implying that entitlement cuts are still off the table. But the deal that has already been crafted has taken away the President's moral high ground. He will not be able to argue that the rich need yet another tax increase to pay their fair share. Didn't they do that with this deal? In the next negotiation, I anticipate Republicans to argue that the President wants only to tax people who are successful and he is unwilling to curtail spending in a responsible way, when that is the fastest growing part of the budget problem. This has actually been the Republican position all along, but it wasn't persuasive or even believable until the Republicans surrendered unconditionally by accepting the tax hikes on high income families. Republicans lost the election because the President was able to label them as protecting the top 2%. With the Republicans accepting these tax hikes now, the President will be unable to come back within the next few months with the same claim. And the next round will be coming soon.
The deal that was struck left unaddressed such issues as the debt ceiling, which Treasury Secretary Geithner indicated would be reached around the end of February. The agreement also deferred sequestration by only two months, which also pushes that deadline until the end of February. Round two in the budget battle, arriving by mid-February, will likely entail Democrats arguing for a debt ceiling hike and another deferral of spending cuts, while Republicans demand the spending cuts they were denied in round one. In that upcoming battle, it will hard for the public to conclude that Democrats are fiscally responsible and Republicans are irresponsible. The opposite is the far more likely conclusion. Now that taxes have been raised on the wealthy, how can the President avoid cuts to spending?
The strange thing about round one was that so many people thought that only a "grand bargain" over the budget made sense. Republicans would accept increases is tax rates on upper income households and Democrats would accept curtailments in entitlement spending, much of which could come in the form of somewhat reduced adjustments to inflation and a hike in the age at which people qualify for Medicare and, possibly, Social Security. (Current legislation has already increased the qualifying age for full Social Security benefits to 67 to be implemented gradually over time.) Thus, the cuts to entitlements would be gradual and spread out over many years. Such a deal would have afforded both sides the political cover for a deal by suggesting both sides made major sacrifices and that only by making these major sacrifices was a deal possible. Indeed, a number of Democrats and Republicans tried to reach a grand bargain in the negotiation, but were unable to do so. Instead, the President got a decisive, overwhelming victory by getting the tax hikes he wanted without any corresponding cuts in entitlements, but this success greatly undermines his negotiating position with regard to the next round and leaves massive deficits in place for the foreseeable future. Of course, the President may be a far more skilled political tactician than I am or I give him credit for. Perhaps he will manage the next round as skillfully as he did this one. I sure hope so. But I am inclined to guess that that we will get to see another bruising budget fight that breaks out openly by mid-February.
The investment implications of the deal are quite positive for the near term, but far less clear looking out over a few months. Euphoria over avoiding the fiscal cliff should enable equities to perform well over the next several weeks, while bond yields should rise. Economic growth prospects have also improved. That's precisely how the markets behaved on Monday, as the politicians appeared to be making progress towards a deal. This euphoria won't last long, however. Negotiations need to start soon, since late February will arrive fairly soon and politicians will be quite distracted over the next few weeks by the activities that normally surround the seating of a new Congress and the appointment of new key personnel in the Administration, such as Secretaries of State and Defense. The market volatility that we experienced in recent weeks should return by mid-February, as the budget battles resume.
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