Phil Taylor
Senior Managing Director, Invesco

By Phil Taylor, Senior Managing Director, Invesco

As we get closer to Jan. 1, the rhetoric around the so-called fiscal cliff is approaching fever pitch. At the same time, consumers don't seem too worried. In October, consumer confidence hit its highest level since 2001.

Why aren't consumers more concerned? That answer will vary from person to person. But I believe the ramped-up rhetoric may be partly to blame.

If you take a cursory glance at the issue, it would be easy to believe that it's an either-or choice: Plunge over the fiscal cliff and launch a new recession on Jan. 2, or swerve and avoid the cliff.

With a choice like that, the answer seems obvious. Even in an era of divided government and polarized politics, would Washington really let the US economy fall off a cliff? Many consumers may simply see this as a grand production of political theater that will eventually reach its inevitable conclusion: a return to business as usual.

What is the fiscal cliff?

At the start of the New Year, up to $600 billion of spending cuts and tax increases are scheduled to occur.

The result would be an immediate and dramatic drop-off in federal deficits — this is what's referred to as the fiscal cliff.

While long-term deficit reduction may be a good thing, it's expected that the economy would suffer from the shock of such a sudden, dramatic drop in spending.

Additionally, taxpayers would see their income fall when their tax breaks expire.

As with most economic issues, the real story is a bit more complex. To be sure, we don't want to fall off the cliff. But we don't want to make a U-turn either, and simply return to fiscal policies that may not be in the best interest of our long-term economic health. We need to change course, but the direction that we choose and how quickly we act matter greatly.

An either-or (-or, -or, -or) choice

Here is a simplified version of the various choices we face.

• Falling off the cliff — and landing at the bottom. This is the path of least resistance: On Jan. 2, policymakers allow current law to take its course and don't look back. Some $600 billion of spending cuts and tax increases would go into effect, leading to dramatic deficit reduction: The US Congressional Budget Office (CBO) says that federal debt as a percentage of gross domestic product (GDP) would fall to 58% by 2022, down from its 2012 level of 73%. However, the CBO also projects that the US economy would shrink by 0.5% and unemployment would rise to a level of 9.1% next year under this scenario. Investors would feel the negative effects in their portfolios as the markets struggled to adjust to the new economic realities.
• Falling off the cliff — then scrambling for a parachute. Many people are focused on what's going to happen Jan. 2 if the fiscal cliff is not averted. But don't forget Jan. 3. And Jan. 4. The Center on Budget and Policy Priorities points out that Congress may have a small window of time to complete a budget agreement after the start of the New Year, but before the brunt of the fiscal cliff is felt. If the upcoming spending and tax changes are allowed to transpire for a brief period of time, that "… should cause little short-term damage to the economy as a whole, since policymakers would surely make whatever tax and other agreements they worked out in January or early February retroactive to Jan. 1. Thus, the delay would withdraw little aggregate demand from the economy." However, even a short delay in this process would likely damage the perception of our political process and our ability to make sound economic decisions. Remember that last year, even though the US raised its debt ceiling right on deadline, Standard & Poor's downgraded the US long-term credit rating partly because of the "prolonged controversy" surrounding the negotiations.
• Making a U-turn. Washington could choose to simply reverse course and leave the cliff in the rear-view mirror by negating the tax and spending changes. The CBO estimates if current policies were maintained, the economy would grow by 1.7% next year, and unemployment would drop to 8.0%. However, the debt would skyrocket — federal debt as a percentage of GDP would rise to 90% by 2022, up from its 2012 level of 73%, the CBO says. Debt that high would be a long-term drag on our economy, and domestic investment would take a back seat to debt service.
• Charting a new course. Chief executives of 80 companies, including Invesco CEO Martin Flanagan, recently issued a statement urging Congress to chart a new course for our economy — one that would gradually bring down the debt so that the economy could absorb the changes without shock. They advocated a bipartisan approach that would reform all areas of the federal budget and include comprehensive, pro-growth tax reform that would increase revenues. The end goal of such a "grand bargain" would be to reduce our $16 trillion debt by $4 trillion over 10 years. You can find out more about this approach through the Campaign to Fix the Debt, a nonpartisan movement that seeks to unite business leaders, government officials, policymakers and concerned citizens, and rally their support for a comprehensive plan to fix our long-term debt in a responsible manner.

Invesco's view

At Invesco, we believe the government needs to chart a new course for our economy — one that balances short-term growth and long-term stability. Policymakers should act quickly and avoid the rancorous posturing that accompanied last year's move to raise the debt ceiling. Working together to enact a sound plan would help businesses and individuals feel more confident about investing for their future, and help alleviate the growing debt burden for future generations.

Important Information

The opinions expressed are those of the speaker, are based on current market conditions as of Nov. 8, 2012, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.