A piece of legislation from 1988, the Worker Adjustment and Retraining Notification Act (WARN Act) may further dampen consumer and business sentiment. This law requires that firms with at least 100 full-time employees anticipating mass layoffs or plant closings must provide 60 days' notice to affected employees (some states, including California and New York, require 90 days). The law's aim was to provide a window for workers to look for new jobs while they were still on payroll. Some companies that would be hard hit by the budget sequester, particularly defense firms, have concluded that they will see major projects cancelled, which will result in massive layoffs starting in January. To comply with the requirements of the WARN Act, they will have to make layoff announcements at the start of November. Such announcements could have a depressing impact on consumer confidence and spending, which would be especially damaging during the holiday November/December retail season. Moreover, the announcements would be made just days before the national elections, possibly influencing voter decisions. The defense contractor Lockheed Martin has said it may notify more than 100,000 employees of potential layoffs ahead of the election. EADS (a major European defense contractor with U.S. operations), Northrop Grumman, General Dynamics, and Boeing are reviewing their situations and may issue layoff announcements.4
The prospect of driving off the fiscal cliff could also harm the economy in the first half of 2014. The reason is that not all of the higher tax liabilities for 2013 would be paid through increased savings or paycheck withholdings during 2013. For example, payments for the new ACA taxes, the AMT, and higher estate taxes would not be withheld in 2013 but would be payable in 2014. Households that do not adjust their 2013 withholdings would face a larger tax bill to be paid during the tax season in 2014; sending larger checks to the IRS in 2014 could be a drag on consumer spending.
Global Impact
It would be a mistake to focus exclusively on the US economy and ignore the rest of the world. By early summer 2012, there were clear signs that the global economy was slowing. Europe continues to stumble from crisis to crisis as its new euro-wide institutions are tested and stressed in ways that the euro's founders never anticipated. Severe fiscal austerity in parts of Europe and an unsettled banking system have pushed much of Europe into recession. In addition, there are signs of slowing growth in China, India and Brazil. If the U.S. were to fall into recession in early 2013 while the rest of world is struggling to find its feet, economically speaking, the result could be a global recession.
The Debt Ceiling Debate: DÉJÀ VU
As if the fiscal cliff were not complicated enough, the U.S. will soon face another debate about raising the federal debt ceiling. We think federal debt will hit its legislated debt ceiling of $16.4 trillion near the end of 2012. The U.S. Treasury will be able to buy some extra time using accounting techniques, as it did in the summer of 2011, to keep the federal government operating even after the debt ceiling is hit. But such tactics can only work for so long. Sometime in the first quarter of 2013, the Treasury will run out of wiggle room, and if the debt ceiling is not raised, the US government would experience a partial shutdown, and there could even be a selective default on Treasury securities.
Congress will debate raising the debt ceiling, as it has many times. The participants have an incentive to continue negotiations until the last minute because this pressures their adversaries to make compromises. The likely outcome of the debate, in our view, will be a last-minute increase in the debt ceiling, similar to what happened in August 2011. The debate is sure to be rancorous as the two parties argue on how to slow the rise in federal debt. Such debates will be revisited time and time again until the country has a better sense of which adjustments it is willing to make to bring the federal budget into balance.
My optimism that the debt ceiling will be eventually raised and that the federal government will avoid default is tempered by pessimism about how another debt-ceiling debate may affect consumer and business confidence in a fragile recovery. The summer of 2011 afforded some bad experience with these matters: As the debt ceiling debate flared in June and July and investors wondered whether the US government would default, various surveys of confidence and sentiment slumped, measures of policy uncertainty surged, the pace of payroll increases slowed, the unemployment rate edged up, and the stock market fell. Granted, some of the economic slowdown should be attributed to the surge in oil prices and financial commotion in Europe, but the timing of the deterioration in survey results suggests that the debt-ceiling debate took a toll on the economy. It could happen again.
In a nightmarish scenario, the U.S. could drive off the fiscal cliff in January, shaking the economy badly. Meanwhile, Congress and the president could get bogged down in a fierce battle in early 2013 over raising the debt ceiling, further depressing sentiment and raising uncertainty. It could be a grim time for the economy.
Our Outlook
In our opinion, the best bet is that the US will not drive off the fiscal cliff in 2013, although we do expect fiscal policy to tighten significantly, probably about one-third of the size of the fiscal cliff. We also expect the debt ceiling to be raised in early 2013 as part of a fiscal agreement; the US will not default on its debt, in our view.
In particular, we expect the Social Security payroll tax cut and extended unemployment benefits to expire as scheduled. We expect moderate reductions in discretionary federal outlays, both defense and nondefense, but we do not think the sequester will be implemented. We expect a renewal of the doc fix and another patch for the AMT for 2012 and 2013, as has been the tradition. The new ACA taxes will be implemented as scheduled, although the Republicans will work hard to repeal them. We do not expect that all of the Bush income tax cuts will be allowed to expire, but we do not think Congress will miss an opportunity to raise more revenue. Rather, we expect that income tax revenues will be boosted, perhaps by capping tax deductions rather than raising tax rates. For the time being, we believe the estate tax will be kept as is. Some expiring tax provisions will be renewed, but the extra capital spending allowances will expire as scheduled.
This amount of fiscal austerity does not match driving off the fiscal cliff, but we believe it would reduce real GDP growth in 2013 by about a percentage point relative to what would happen if current policies were maintained.