Thursday, August 23, 2012

CBO Sounds Off On Fiscal Cliff

In case you weren't aware that the U.S. government is in poor financial condition, the Congressional Budget Office issued a new warning that automatic fiscal discipline will cause a recession in 2013 unless Congress passes a sensible deficit reduction effort.  Warnings like this are easy to turn into political cannon fodder but miss the larger implication of fiscal discipline.  The patient must take the medicine at some point, and it is better to do it immediately than postpone treatment into the indefinite future when the consequences will be even more severe.

The Fed's propensity to act in the absence of Congressional action is now more pronounced.  The Fed issues ever clearer statements of intent and there is now silence from anti-inflation hawks.  The last two rounds of quantitative easing had progressively diminishing effects.  If QE3 is launched before the November elections, the equity market pop might last a few months but fundamentals like factory orders and consumer confidence won't move much.  Agricultural commodity prices are already high thanks to a record U.S. drought, so juicing price inflation with no corresponding wage growth will not bode well at all for the holiday shopping season.

Europe offers us an abject lesson in crisis non-resolution.  The Continent's geopolitical power suffers as its sovereignty crunch continues without firm solutions.  The decisive answer for Europe is to remove incompatible countries like Greece from the currency union.  A decisive answer for America would be a fiscal agreement that is serious about deficit reduction.  A firm agreement can fall short of the penalty imposed by a fiscal cliff but must be serious enough to show equity markets that the U.S. possesses leaders willing to risk short-term pain for long-term solvency.