Congress and the fiscal cliff by Wells Fargo’s Chief Strategist.

This is a very well written article by Wells Fargo’s Chief Strategist about the fiscal cliff and how congress will react to it.  We strive to provide up to date and pertinent information to our readers.  Please take a look at this article.

What Will Congress Do About The Fiscal Cliff?

The U.S. economy faces a potential recession in 2013 if Congress does not take action to avoid the fiscal cliff. The Congressional Budget Office estimates that U.S. economic output could contract 0.5% in 2013, if all scheduled tax increases and spending cuts take place starting in early 2013. At this point, we do not expect this worst-case scenario to happen. Both parties favor avoiding the fiscal cliff. Of course, their proposals are different.

We have been saying for months that investors will probably not know how Congress will address the fiscal cliff until after the November elections. That’s because neither party knows whether their proposals will dominate the policy decisions. After all, the election will determine which party gains seats in Congress and controls the White House. Fortunately, the election is less than a week away. Therefore, investors may not have to wait much longer to get a clearer picture on how Congress is likely to deal with the pending tax hikes and spending cuts.

A recent Wall Street Journal/NBC news poll asked survey participants about how they would prefer Congressional Leaders to address the deficit problem. The responses suggest that the public is tired of a divided-ineffective government, with 75% of respondents saying that they would prefer that Congressional Leaders compromise over the deficit, while only 15% said that they want leaders to stick with their positions. This suggests that the newly-elected Congress has public support to find some middle ground and avoid going over the fiscal cliff. We don’t expect a wave of bi-partisanship to develop between the two major parties after the elections. But we could see a kind of detente between lawmakers as they address this serious and potentially damaging problem.

We believe there are three scenarios for the fiscal cliff. First, Congress could do nothing, allowing country to go over the cliff and causing a modest recession in 2013. We believe this is the least-likely scenario. Second, Congress could decide to just postpone the tax increases and spending cuts and move the fiscal cliff forward to be confronted in another year or two. This strategy would probably look irresponsible and could lead to a downgrade of the U.S. debt rating. The third and most likely scenario would be a compromise on tax hikes and spending cuts that limits the damage to the U.S. economy but dampens economic growth next year.

History shows that reducing the deficit would probably hurt the economy in the short run but would potentially create a healthier economic environment over the long term. Once the election is over, Congress will need to consider what the economy could endure from a compromise that raises some taxes and cuts some spending.

Congress will need to find an acceptable mix of taxes and spending that both parties can support. This will not be easy, and is unlikely to be done quickly. Nevertheless, investors should get a better idea about the direction that Congress will go soon after the election. If the Democrats retain the White House and control of the Senate, investors should expect proposals that would trade tax increases on wealthy taxpayers for smaller cuts in defense spending. If the Republicans win the White House and pick up more seats in Congress, then there is likely to be some temporary measure to avoid the fiscal cliff as the new Administration works on tax and spending reforms, not just changes to existing rates.

At this point, we believe that the uncertainty of the fiscal cliff could dampen economic activity early in 2013. However, after the fiscal cliff is addressed, we would expect economic momentum to build as the year progresses. For the year as a whole, we currently expect economic output to expand at an inflation-adjusted 2.5% rate in 2013. This would still be slightly less than the 2.8% thirty-year average. However, economic growth would probably be even better if the deficit was already reduced and the country did not face tax increases and spending cuts next year.

fiscal cliffThe approach of the fiscal cliff has been widely anticipated by businesses and investors. The uncertainty ahead of the fiscal cliff probably dampened business investment and hiring this year. If Congress takes action and avoids sending the country over the fiscal cliff, then companies may be more inclined to invest and hire again. Thus, concerns over the approaching fiscal cliff have already put strains on the U.S. economy. Congressional action to resolve the fiscal problems could open the door for a better economy next year. Congress just needs to get to work and avoid the political impasse that occurred during the debt-ceiling extension and U.S. debt downgrade in August of 2011.

The lack of action to address the fiscal cliff before the election was understandable. However, after the election, we expect investors to be less tolerant of further delays. Investors should know relatively soon if Congress is serious about avoiding the fiscal cliff.

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