Thelma and Louise, James Bond, Frodo Baggins and the Inception Cast
Following the election, financial and non-financial presses alike gravitated rapidly to the topic of the fiscal cliff. At present, lead articles on the Wall Street Journal, Financial Times, CNBC, Fox News, and CNN splash pages all give top billing to the fiscal crisis and its implications for Main Street. American citizens are no different – Google Trends analysis reveals that searches on the term “fiscal cliff” on November 7th were 12 times more frequent than at any other point in the previous ninety days. Clearly, it’s on our minds.
There are many scenarios that could play themselves out over the next fifty days, as Congress and the President work to find compromise in order to avert the tax hikes and spending cuts that could further damage the frail economy. Washington’s leaders could structurally reform the tax code and spending system, postpone meaningful change by deferring the cliff to a later date, or drive us off the cliff altogether. Some economics departments of large financial institutions have begun to publish the projected probabilities for each of these outcomes.
However, given both the myriad potential outcomes and the complicated incentives of the individuals wrangling over them, we’d feel uncomfortable trying to assign probability weights to them. That said, we do think it’s sensible to try to portray what would happen in each of the potential scenarios. And to depict them, who better to enlist than our national storytellers from Hollywood?
The Fiscal Cliff as Financial Cataclysm (Thelma and Louise): It’s been twenty years since Callie Khouri picked up her Best Screenplay Oscar for Thelma and Louise, the story of two women’s flight to freedom from the men who mistreat them and the authorities who hunt them. As Thelma and Louise travel together, they shoot a would-be assailant and rob a convenience store, attracting police attention. At the close of the film, with the FBI and police surrounding their Thunderbird on the brink of a massive ravine, they join hands and accelerate off the cliff.
In this worst-case scenario, it’s President Obama and House Speaker Boehner driving the economic car, but they cannot find compromise in the various demands placed on them by taxpayers and interest groups. Even as their advisors surround them and implore them to stop and talk, they join hands and drive the US economy off the fiscal cliff.
If this depressing movie plays out, hedgers could be exposed to more extreme volatility across the board. On the one hand, if the federal government seems like it’s accelerating towards the cliff, the US faces further sovereign downgrades which could raise borrowing costs rapidly. By contrast, the lack of meaningful fiscal reform could further perpetuate Bernanke’s quantitative easing and put downward pressure on rates. Should falling off the fiscal cliff lead to recession, a point on which most all economists concur, commodity prices excluding gold could face significant downward pressure; on the other hand, the regulatory and economic environment surrounding certain energy sources like coal could raise the price of substitutes.
The Fiscal Cliff as Impetus for Resurgence (Skyfall): In the opening scenes from Skyfall, the latest film in the James Bond franchise, Agent 007 grapples with a professional hitman on the roof of a train outside Istanbul. While the train crosses the Varda Viaduct above a deep creek canyon, Bond’s fellow operative accidentally shoots him, and his limp body sinks deeper and deeper into the water, presumably dead. However, once M’s office is destroyed in a huge explosion along with many MI6 colleagues, Bond returns from his hiding place with renewed resolve to fight and greater success than before.
In this version of potential events, the US falls over the fiscal cliff and spends a few months sinking under the full weight of sharply increased taxes and reduced spending. As the economy plunges deeper into recession, and the unemployment rate continues its skyfall, cooler heads prevail and reach compromise. The resurgent American economy comes back stronger than before, with plenty of challenges in its future but no more cliffs.
Should this action film play out, a few months in 2013 of sharply higher income, dividend and payroll taxes will be enough to plunge the economy into recession, but Washington will come to its senses and come back with a renewed urge to compromise. If meaningful tax and spending reform occurs, promoting growth, this could lead to increased interest rates to prevent inflationary pressures. The dollar could strengthen against the euro, particularly if there is continuing concern about the monetary union’s fiscal viability relative to the US. Economic growth could also lead to increased demand for energy and industrial commodities.
The Fiscal Cliff as Narrowly-Averted Catastrophe (Lord of the Rings): In the iconic scene from The Return of the King, Frodo Baggins finally reaches the narrow precipice above the fires of Mount Doom, then has second thoughts about throwing away the ring of power and seeks to keep it for himself. Only because Gollum shows up and bites off his finger, then plummets into the fire below, is the evil lord Sauron destroyed forever. Frodo and Sam flee the precipice as rapidly as possible, even as the fires from below threaten to consume them.
In the contemporary retelling, Congress and the President are on the verge of falling over the fiscal cliff, each one seeking to trumpet its own power and influence over the process. Just then, European financial crisis in the form of Grexit happens first (where a painfully thin Gollum represents the Eurozone after years of belt-tightening austerity programs). Realizing how bad things could get, the Americans decide to reach compromise and flee the precipice as fast as they can, with the fires of contagion pursuing them from behind.
In this gut-wrenching thriller, either taxpayers around the EU revolt against further transfers to the troubled states, or the parliaments of the states themselves reject the terms of further financial payments. Should the Eurozone enter into crisis as one or more members exit the common currency but America get its fiscal house in order, there would be incredible near-term volatility connected to the euro. Predicting appreciation or depreciation is impossible without knowing which nations would leave the euro and which would stay, but such a move would be sure to roil the currency markets considerably.
The Fiscal Cliff as Multiple Wake-up Calls (Inception): The stunning denouement of Inception involves the intricately timed and coordinated fall of three groups of dreamers. For the team to accomplish its corporate inception mission, such that the heir to a massive rival energy conglomerate will decide to dismantle his business, they must wake up simultaneously from falling through a collapsing hospital, down an elevator shaft, and off an elevated bridge. As some members of the team succeed, they see themselves falling first through snow, then an elevator shaft, and then splashing down inside a van.
In the best-case scenario, the President and Congress realize that it will take a coordinated team effort to face the many potential falls that lie ahead of the US economy. Beyond the nearing fiscal cliff, they will embrace cooperation and intricate coordination to address burgeoning health care costs, Social Security funding shortfalls, and the staggering national debt. Each fall will represent an increased awakening to the level of coordination needed to wake up before landing and avoid the economic limbo of a lost decade.
In this heart-warming film, the United States would restore its sterling AAA rating rapidly, as investors worldwide could witness its evident commitment not to spend beyond its means. Equity and debt markets would have calm assurance in the well-functioning of the government, and the predictability of its policy measures would help companies make investments for growth.
No one knows for sure whether the upcoming fiscal cliff will usher in financial cataclysm, the wake-up call our elected officials need, or something in between. For certain, the issues have stalked American politicians for a long time – fifty years ago, President Kennedy’s budget message to Congress included the reminder that “lower rates of taxation as well as tax reform measures will stimulate economic activity and so raise the levels of personal and corporate income as to yield within a few years an increased–not a reduced–flow of revenues to the Federal Government” – Kennedy’s contention then is a central element of the controversy even today! So whatever materializes, we’re always happy to discuss the risk management ramifications for you – don’t hesitate to give us a call.