KOO, THE BSR AND THE COMING “FISCAL CLIFF”

Richard Koo’s latest note has some good insights on the potential risks to the economy in 2013 as government spending slows.  He cites what could turn into a “fiscal cliff”:

“Concerns about fiscal cliffs are nothing new: Fed officials have been talking about it for the last six months. Initially they were worried about the fiscal cliff approaching on 1 January 2012.

As of last autumn, the payroll tax cut and the Bush-era tax cuts were scheduled to expire at the end of 2011. Fed officialswarned Congress and the administration that the US economy would be in serious trouble if the tax cuts were not extended.

Fortunately, the tax cuts were ultimately extended by a year, and the fiscal cliff at the start of 2012 was avoided. But now we have not only the expiry of those tax cuts but—also on 1 January 2013—the enactment of the mandatory spending cuts contained in last August’s fiscal consolidation agreement. The resulting “fiscal cliff” will therefore be even more severe than the one people were worried about on 1 January 2012.

The Fed chairman has asked Congress at the very least to prevent these things from happening on the same day, but I suspect what he really wants is for these measures to be extended again.

That was clearly hinted at when the Fed announced that it would keep interest rates at exceptionally low levels at least until the end of 2014. They understand that it will take at least that long for the US economy to recover from its balance sheet recession and that, until it does, both monetary and fiscal policy will have to be fully mobilized to support the economy.”

Obviously, we haven’t seen much in terms of austerity in the USA and it’s one of the main reasons why I’ve remained out of the double dip recession camp.  This was the power of understanding the balance sheet recession (BSR).  If you knew that the government was propping up spending through deficits while the private sector was deleveraging then you understood why Europe is cratering and why the USA is not.

I’ve long said that I think the BSR could end by 2013/2014.  Rather, that the de-leveraging could slow to a point where it slows the private spending bleed and doesn’t require $1T+ deficits any longer.  But the risk in 2013 is that we’re going to slam the breaks resulting in Koo’s “fiscal cliff”.   Based on the latest CBO estimates the deficit is likely to decline from over $1.079T this year to  $585B in 2013.   That’s a substantial drop.  Not necessarily a “cliff”, but not far off.  In this case the domestic private surplus will shrink to ~2% assuming the current account remains around $400B.  That’s a large decline from this year’s expected ~5% balance.

The question mark in all of this is private credit growth.  We’ve actually started to see some signs that loan demand is coming back.  Consumer credit is improving and total loans at commercial banks is on the mend.  That’s expected as the BSR effect slows, housing stabilizes and big deficits continue to bring the economy back to something resembling normal.  Recent household debt accumulation is back to a 2.9% year over year rate.   That’s a clear sign that the private sector is beginning to run with the baton as time goes on.  But I don’t think we’re ready for a full hand-off yet.

If we input all of this into my economic model (which is not calling for recession this year) we can see what happens if spending really does decline, credit growth remains modest, the current account remains close to where it is and inflation doesn’t surge (you can see all the moving parts that go into this mess we call “forecasting”!!).   What happens in th scenario that the CBO describes in 2013?  Economic growth starts to contract again at a -1.5% rate and at some point in 2013 Lakshman Achuthan gets to say “I was right after all!!”.   Of course, the big question mark here is, will we actually near the cliff?  So far policymakers have extended most of the spending out into future years.  So we’ll wait and see how things progress.  We’ll have a more definitive perspective later in the year, but for now, I think it’s still safe to say no recession in 2012, but substantially higher risks in 2013….