What’s on the Menu? US!

Reuters is reporting that taxes are “on the menu” today in ongoing discussions between VP Biden and several key members of Congress:

Participants in the Biden group say they have made steady progress since talks began early last month, and have conditionally agreed on at least $150 billion in cuts. But that is far short of the roughly $2 trillion in deficit reduction needed to ensure that Congress will not have to revisit the debt ceiling issue before the November 2012 elections.

Democrats and Republicans agree that the United States needs to reduce deficits by $4 trillion over the coming decade to ensure its debt remains at a manageable level.

If the author is correct that there’s little to no debate over the need to cut $4T over ten years, then the die for asset classes has pretty much been cast. Residual income from equities and assets such as high-yield debt will become a far more challenging game over the next decade. The U.S. dollar is likely to strengthen. Commodities and emerging markets will begin to suffer at some point, once U.S. austerity begins to bite. And the long-end of the Treasury curve has a ways lower to go. That’s right—lower. It might involve some ugliness if Congress does play chicken into August or worse. But inevitably, real growth is going to fall, inflation is going to surprise to the downside longer-term, risk aversion will return, and there will be a scramble for the (almost!) guaranteed positive yield that longer-term Treasuries still offer (despite the all-too-common error of believing that real Treasury yields are negative based on the relative price distortions caused by levered speculators and their hoarding counterparties).

The fed funds rate is going to remain anchored near zero for longer than almost anyone expects. That does not argue for a rising term structure. The household sector is still trying to repair balance sheets, a decade- or decades-long process. That doesn’t argue for excessive credit creation or aggregate demand. And recent economic performance in the face of rising commodity prices has driven home the point that prevailing market paradigms around monetary policy and fashionable allocation trends are causing disruptive relative price shifts, insofar as more expensive food and energy simply substitute for other goods in the typical ‘consumption basket’. That is decidedly not inflation, much less the dreaded hyperinflation.

There’s a class of economists out there who argue that fiscal multipliers (the overall spending that results from a dollar of government spending) are no better than one, as bad as zero, and possibly worse (which might in fact be possible, but only under exceedingly unusual circumstances). The common assumption, and it’s one that GOP presidential candidate Tim Pawlenty hammered on in a recent speech, is that the private sector always stands ready to put resources to use in the most productive manner if only government would get out of the way. Certainly such situations exist from time to time, but the free-market dogma has gone completely over-the-top in recent years, especially when you consider the overall shape of private sector finances and income today, the damage that’s been done by financial deregulation, and the inescapable reality that the baby boomers are no longer going to be the private-sector economic juggernaut that they were for the last forty years.

More objective and convincing arguments have been made that when monetary policy faces a zero-bound, as most developed economies’ central banks do now, that fiscal multiplers are large—anywhere from 1.5x to as high as 4x. In other words, for every marginal dollar added to the federal government’s net spending, whether from additional spending or lower taxes, anywhere from an additional $0.50 to $3.00 of total income is created (once you get your head around how fiat money works, you add back that initial $1 of spending as well). Unfortunately, the power of fiscal multipliers holds true on the downside as well, i.e., fiscal consolidation can have more negative effects than a mere dollar-for-dollar reduction in output or demand, especially in the economic circumstances prevailing today, as the U.K. and parts of the eurozone can already attest to.

So without going into why they’re completely off base to begin with in worrying about the “manageability” of U.S. Treasury debt, let’s say that Congress eventually does agree to and implement $4T worth of deficit reduction via some combination of spending cuts and tax hikes. If the U.S. economy were to average about $16T per year over the next decade, $4T in cuts represents about 2.5% of overall economic activity ($4T / [$16T x 10] = .025). Even if we assume a multiplier of one, you’re talking about a net effect of zero or negative growth under fairly pessimistic but potentially very realistic assumptions of 2.5% or less annual growth, and very meager growth under a rosier 3% to 4%-plus assumption. Add in potential multiplier effects and it gets much uglier. How do you spell J-A-P-A-N?

Mike Norman of John Thomas Financial has done a nice job outlining how this dynamic works here (pdf). See especially pages seven to nine.

Markets seem to be taking it all in stride today. Some form of agreement would at least remove the uncertainty around August’s Treasury debt payments and rollovers, and as we pointed out earlier today, initial jobless claims didn’t contain any negative surprises, even though the headline disappointed. But the China and other emerging-market risks remain in play, as does the potential for more negative shocks out of Europe. And with the austerity fetish still gaining traction in the U.S., the longer-term outlook for risky assets keeps getting worse, even at their currently somewhat-attractive levels.

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