Fed Chairman Bernanke’s response to the Great Recession was direct – support overall demand and asset prices while the private sector deleveraged – otherwise, private-sector confidence would collapse and recession would turn into depression. So the Fed cut interest rates aggressively and Bernanke adopted many of the unconventional measures he had first talked about in his infamous 2002 deflation speech. Meanwhile, the U.S. government significantly eased fiscal policy. The plan, presumably, was to reverse these policies when the adjustment in house prices and private-sector debt was complete and the recovery had gained sufficient momentum to become self-sustaining.


So far, the strategy is broadly on track. Households have reduced indebtedness, home prices have adjusted and US trade competitiveness has improved. Private-sector confidence and inflation expectations swooned but didn’t collapse and the economy has continued to grow, albeit at a sluggish pace. In fact, the medium-term prospects for the economy now look reasonably good. Yet, Mr. Bernanke still has two main concerns: 1) The impossible situation in Europe, which could unravel at any moment, and 2) The US’s ‘fiscal cliff’ at the end of the year when, based on current laws, the economy faces a 5% of GDP budget tightening. Even with further monetary stimulus from Bernanke, U.S. economic growth could slow dramatically.


The Congressional Budget Office (CBO) estimates the ‘fiscal cliff’ as a $780 billion tightening, or 5% of GDP. Various tax cuts are set to expire at the same time the government plans to cut spending.

  • The sunset of Bush tax cuts, agreed to in 2001, will hit disposable income by $290bn (1.9% of GDP)
  • Obama tax cuts, due to expire, will see the payroll tax rate rise back to 6.2% (from 4.2%); worth $120bn (0.8% of GDP)
  • Automatic expenditure tightening in the Budget Control Act will reduce 2013 outlays by $85bn (0.6% of GDP)
  • Unemployment benefits are set to fall by $34bn (0.2% of GDP)
  • There are another $135bn (0.9% of GDP) worth of cuts that are not linked to specific policies

Clearly a 5% tightening would have a substantial impact on the US economy. But that assumes all the planned consolidation will actually take place. Most investors and economists seem to believe that is unlikely. They think/hope politicians will ultimately smooth the required fiscal adjustment over a longer period of time; they may be right, but there are significant risks to that view.


To start, it is important to recognize the US has a genuine fiscal problem. With net debt around 75% of GDP and a budget deficit at 10% of GDP, US debt is on a trajectory towards unsustainable Italian/Japanese levels. Ideally the US authorities should commit to a medium-term strategy, while ensuring a gradual adjustment. But that might not work politically, for two reasons. First, the election could result in a Congress that can’t agree on how to deal with the deficit and will only have a few weeks at the end of 2012 – during a Lame Duck Session – to sort out this mess. Second, it is possible a new US government would want to frontload the fiscal adjustment in order to improve its re-election prospects. Even a 2% tightening would damage an economy that remains in a fragile state.


That would undermine Bernanke’s strategy of the last few years. More quantitative easing (QE) might be inevitable in such a scenario, but it seems unlikely monetary policy could fully offset the impact of a substantial fiscal squeeze. Besides, the impact of QE appears to be diminishing over time. The only way to offset the diminishing returns from QE would be to adopt more radical versions of this policy. But radical policy isn’t easy; others on the FOMC are likely to oppose it.


We expect the Spanish banking crisis as well as Greek elections to add volatility to closed-end funds and the investment markets this summer.



Michael Ashley Schulman, CFA

Managing Director