What's a fiscal cliff and is the US about to fall off it?

US growth will drop next year if Congress and the President can't come to an agreement to steer away from the "fiscal cliff". Politics will decide if the US goes off the cliff or avoids it.

Last summer, Congress's delay in raising the US debt ceiling cost the country its AAA rating. The compromise that finally got the higher debt ceiling approved created the fiscal cliff that's now looming.

In a nutshell, the fiscal cliff (which could also be thought of as the triple witching hour) is what will happen to the economy when the tax cuts in the $747 billion stimulus package run out, some or all of the Bush tax cuts are allowed to expire, and the automatic cuts to federal expenditures beginning in 2013 Congress approved late last year take effect.

Estimates put the impact of the cliff at 5 points of GDP. Ouch...

Fixing LIBOR...

Barclays Bank is in the spotlight for submitting its LIBOR fixes to benefit its trading positions. It's not the only major bank to have engaged in the practice. Investigations should soon result in charges being filed against other "too big to fail" banks. Institutions that have said they are being investigated include Citi, JP Morgan Chase, Royal Bank of Scotland, UBS, and Credit Suisse.

The scandal underscores that trading has replaced lending as the lifeblood of banking. The nature of the bank-client relationship has changed. Clients have become counterparties, which translates into "buyer beware". Financial institutions don't have the same fiduciary responsibility to counterparties as they do to customers.

Who takes the losses that offset the traders' gains from manipulating LIBOR? Counterparties to the trades did. Some  can be considered sophisticated investors. Several hedge funds and some traders have filed suit on contracts traded through the Chicago Mercantile Exchange. Charles Schwab filed a complaint in 2010.

Others, like cities, relied on the advice of their bankers. Some US cities are suing to recover the losses that artificially low LIBOR rates would have caused. Here's an example of how it works. A city enters into an interest rate swaps based on LIBOR. The bank pays its municipal counterparty a variable payment based on LIBOR. The city pays the bank a fixed payment. If LIBOR is artificially low (because of rate fixing), the city receives a smaller payment. Nassau County's comptroller estimates that the county may have lost US$13 million (on swaps on outstanding bonds with a face value of $600 million) because of rate fixing.

The suits will be very difficult to win. But, banks that are suspected of fixing rates can expect to spend "tens of billions of dollars" on lawsuits, according to a professor at Stanford University.

More importantly, the trust indispensable to well-functioning markets will be further undermined.

Anything worth mentioning about the election results?

As anticipated, Mexicans returned the presidency to the PRI on July 1. Enrique Peña Nieto, the nominee of the PRI and the Green Party, sailed to victory over the PRD and PAN candidates: with 95% of votes counted, Peña won 38.1% to AMLO’s 31.7% and Vasquez Mota’s 25.4%.

What’s worth mentioning about the results? For one, Peña’s margin was much smaller than the daily polls published by El Universal newspaper in conjunction with the reputable survey firm GEA-ISA projected. The final poll before the elections gave Peña 46.9% of the vote, 9.2 percentage points more than he actually received. The 14-16 percentage point margin Peña enjoyed in the polls earlier in the campaign eroded to just 6.3 points on July 1. So, although Peña won comfortably, his victory wasn’t the landslide that had been anticipated.

Neither did the PRI win control of Congress. Although the PRI and its coalition partner, the Green Party will hold more seats than any other party or coalition on both chambers of Congress, they will not hold a majority in either house.

Including the seats won by its Green allies, the PRI-Green’s 232 seats fell well short of the 251 seats required for an absolute majority in the Chamber of Deputies. In fact, the coalition won fewer seats than the 239 the PRI alone held in the previous legislature. The two parties’ seat total fell by 30. The 2014 election could give Mr. Peña an absolute majority in the Chamber of Deputies but, for the next two years, he will have to look for the votes he needs to pass legislation from other parties. Even if Peña can bring along all ten of the Panal’s deputies, he will still have to get some of the votes he needs for a majority from the PAN or the PRD.

In the Senate, the PRI-Green alliance did better. They are expected to win 57 of the chamber’s 128 seats, 16 more than in the previous legislature. Unlike the US where a third of the Senate is elected every two years, in Mexico all senators’ terms run the same six years as the presidential sexenio. The July 1 voting means that unless the new president can persuade some senators to change parties, he will never have a majority in the Senate. And, the senators whose votes he needs will have to come from the PRD or PAN.

Voters left no doubt they are disillusioned with the PAN. Their presidential candidate, who garnered only a quarter of the vote, was almost as far behind the second place AMLO as AMLO was behind Peña. In the Chamber, the PAN also finished third, behind the PRD and its Worker Party (PT) and Citizens’ Movement (Movimiento Ciudano) allies.  The PAN is expected to end up with 118 seats, 24 less than in the prior legislature. The PAN is expected to be the second largest party in the Senate. Its expected 41 seats will be nine fewer than before.

Although AMLO lost by a much larger margin than his razor thin 2006 loss, the PRD and its allies picked up a hefty 52 more seats in the Chamber of Deputies. Their expected 140 seats will make the left the second largest grouping in the Chamber for the next two years. The party’s gains came at the expense of the PAN and PRI-Greens, which dropped 24 and 30 seats, respectively. The PRD-PT-Citizens’ Movement coalition lost four seats in the Senate. With just 29 seats, the left will be a distant third force in the Senate.

Foreign direct investment will soar in 2012...

Foreign direct investment (FDI) just went through the roof. InBev's announcement that it will pay US$20.1 billion to assume control of Grupo Modelo could well put this year's FDI above the 2007 record of US$31.3 billion. No need to worry about 2012's capital account surplus -- unless portfolio investors were to abruptly liquidate their holdings of money market obligations.

Remember: although the US$20.1 billion InBev will pay Modelo's shareholders counts as FDI, it does not mean that money will swell the supply of dollars for sale in the exchange markets which, all other things being equal, would strengthen the peso. Watch for the effects of this transaction in the capital accounts in the balance of payments the rest of this year.

The evidence on supply side economics...

The Institute on Taxation and Economic Policy looked at growth rates in states with and without an income tax. The conclusion: per capita growth in the nine "high tax states" between 2001 and 2010 was higher than in the nine "no tax states" and than in the 50 state sample.

The numbers: average increase in per capita economic output, 2001 - 2010

50 states                   8.1%
9 "no tax" states        8.7%
9 "high tax" states   10.1%

Change in median household income, 2001 - 2010

"no tax" states       -3.5%
"high tax" states    +0.7%

For more, see http://www.itepnet.org/pdf/junkeconomics.pdf

Pass through...

For many years when the peso devalued, inflation rose. Theoretically, only the price of "tradable goods" should rise with a devaluation. In practice, in Mexico, all prices increased. One of the major accomplishments of the macro-economic stability forged over the course of the last 25 years is that the link between devaluation and inflation, the "pass through" effect, was broken.

In the 2009 crisis, the average fix exchange rate devalued 17.5%. Notwithstanding that, inflation fell from 6.5% in 2008 to 3.6% in 2009. It's a striking contrast to 1995. That year, the average annual fix exchange rate devalued 45.1%. Inflation soared, climbing from 7.1% in 1994 to 51.2% in 1995.

That the pass through is no longer automatic doesn't mean that it no longer happens. The average monthly fix exchange rate devalued 9.6% between March and June 1-22. The inflation figures for the first half of June show that the devaluation is finally hitting price levels. In the first two weeks of this month, merchandise prices (the component of inflation in which the impact of a weaker peso shows up first) rose 0.26%, more than the overall inflation rate. In 15 days, merchandise prices rose by nearly as much as they did, on average, in each of the prior three months. If the peso doesn't revalue, inflation could exceed 4% this year.

The finances of US households...

The Fed's portrait of the "median family's" finances in 2010 has some sobering figures. Things got worse, not better for American families between 2007 and 2010.

INCOME AND NET WORTH: Median family earnings in the US dropped 7.7% between 2007 and 2010. Median family net worth (half of families' net worth was higher and half, lower) came in at $77,300 in 2010. The housing crash explains 3/4 of the drop from 2007's $126,400 median net worth. The median amount of home equity fell to $75,000 in 2010 (from $110,000 in 2007).

SAVINGS & DEBT: The percentage of families who saved during the year fell from 56.4% in 2007 to 52% in 2010. Since total savings have risen, it means that a smaller group of families is saving more. Nearly three-quarters (74.9%) of families still had debt in 2010. The median amount of debt in 2010 was the same as in 2007. So much for the success of households in deleveraging... The percentage of families without credit cards rose from 27% in 2007 to 32% in 2010. The percentage of families with credit card debt fell to 39.4% (from 46.1%). The median balance dropped 16.1%, to $2,600.