Copyright 2012. Tom Madell, PhD, Publisher
Feb. 2012

Political Storm Clouds

by Steve Shefler

The threat of continued political gridlock in the new term of Congress poses a significant risk that could drive stocks back to their October lows.

On December 23, the Congress passed a two month extension of three programs: (1) the payroll tax cut, first enacted in December, 2010; (2) extended unemployment compensation enacted in 2008; and 3) continued deferral of the 27% cut in doctors’ Medicare reimbursement rates mandated by the 1990 debt reduction package.

In the next 30 days, the Congress will be faced with the challenge of extending these benefits for the remainder of the year. If they fail to do so, it is generally agreed that the economy will suffer fiscal/spending cuts that will slow economic growth. Moody’s estimates failure to make these extensions will subtract 1% from the Gross Domestic Product. Goldman Sachs says the setback could be as high as 2%. Moreover, the psychological impact from workers’ decreasing paychecks and Congress’ inability to co-operate could be devastating.

President Obama and Congressional leaders, both Democrats and Republicans, have expressed support for full year extensions of all three initiatives. The key disagreements will be about whether to and how to pay for the extensions. To fully pay for the additional ten month extensions will require $170 billion in spending cuts, revenue increases or some combination of both.

One important potential area of disagreement concerns whether the extensions should be paid for. When President Obama first proposed the extensions last September, he was emphatic that they would (and implicitly should) be paid for. The two month extensions were paid for, mostly by future increases in fees charged for federally guaranteed mortgage loans. Previously both the Democrats and Republicans made proposals for full year extensions that would be fully paid for albeit in vastly different ways. Neither passed and the year ended in stalemate.

Following the interim two month extension, a committee of 20 Senators and Representatives was set up to negotiate the additional ten months of extensions. It initially focused on how the extensions would be paid for. However, in mid-January the House Democratic leadership challenged the premise that the extensions should be paid for. Democratic Leader Pelosi argued that paying for the extensions would slow the economy at the very time it needed stimulus, and that “pay-fors” have never been required for emergency unemployment insurance or tax cuts. The Republicans, on the other hand, have been emphatic that any extensions must be paid for.

Another potential stumbling block to any agreement would be insistence by the Democrats that a portion of any “pay for” solution comes in the form of increased income taxes on the wealthy. More than 50 Senators (mainly Democrats) supported such an increase last fall. As a result of a filibuster by the Republicans, the measure fell short of the 60 votes needed for passage; however, the Democrats have not forsaken this demand. In January, both Senate and House Democratic leaders Harry Reid and Nancy Pelosi indicated that taxing the wealthy should be part of any “pay for” plan.

President Obama has publicly endorsed increased income tax on the wealthy to pay for the payroll tax extension. The Republicans are unlikely to agree to any increase in income taxes on the wealthy; 95% of Republicans have signed the Norquist pledge not to raise taxes. The Republican leadership has been adamant in its opposition to such increased taxation. While the Democrats might back off on insisting a surcharge for high income earners be imposed, their position remains in flux.

To be sure, there is a path whereby the extensions could be paid for without increasing income taxes. Last fall, the Republicans passed such a plan in the House of Representatives. It included such elements as a further one year freeze on federal employee pay (currently two years), a 10% reduction in the federal workforce by attrition, increased Medicare fees for wealthy individuals, and decreased Medicare payments to hospitals. The Democrats rejected the proposal due to the absence of increased income taxes and disagreements with proposals such as cuts to the federal workforce.

Numerous other proposals have been floated to come up with the funds to pay for the extensions. In the course of this short piece it is not possible to discuss all the numerous “pay for” concepts. For example some Democrats have suggested that they be paid for by the savings from pulling out of Iraq. Republicans have correctly countered that this would be a smoke and mirrors solution because it would not entail cutting already approved expenditures. Other proposals include shutting the Post Office on Saturdays, and cutting child tax credits for the children of illegal immigrants. Most of the suggestions are controversial and would individually only pay for 10% or less of the cost of the extensions, over a ten-year period. Putting together a multi-component program will be challenging.

In addition, Republicans have threatened to demand policy changes in any extension bill such as mandatory drug testing for recipients of unemployment compensation. They have also threatened to again insert a Keystone Pipeline mandate into the legislation. There are so many moving pieces in the on-going discussions that only a broad overview is possible.

Anyone who has observed the negotiations over these extensions and the national debt during the past year is aware that partisan warfare and efforts to outmaneuver or blame the other party have driven the debate, not any real intentions to compromise on the issues. President Obama may in fact be ambivalent, since he would like the extensions to bolster the economy and his chances of re-election, but recognizes that if the legislature fails to enact the extensions he can run against a do-nothing Congress that has harmed the economy. Further, the fractured state of the Republican Party will hamper any compromise. How do you compromise with the Democrats when you don’t have your own act together, and when Republican leaders do not seem to have control of their troops? Republican Congressman Michael Grimm in a recent New York Times interview expressed the opinion of many: “I wish I could say the coming year will be better in terms of more bipartisanship. But I don’t think it will.” In short, the hurdles to an agreement are high.

In the past week, both President Obama and Vice President Biden have indicated that passing the extensions was their highest priority. Speaker Boehner and Republican Senate Leader McConnell have expressed confidence that the extensions would be agreed on. But neither side has provided any details about how such a middle ground will be reached. Investors have been diverted by a host of other news stories while the payroll controversy has faded into the background.

Investors should keep in mind that (1) it is highly unpredictable how the extensions issue will play out; (2) there is substantial risk that the parties will not reach common ground; and (3) if no compromise is reached, there is a high likelihood that stocks will suffer a major setback. Keep in mind this is not some abstract future threat. In the next 30 days, Congress must pass a full year or further temporary extension, and if they fail an adverse market reaction seems likely.


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