Of Irish and Fiscal Cliffs
Franklin Templeton Investments
October 26, 2012
When faced with a seemingly insurmountable challenge, it’s tempting to stick one’s head in the sand like an ostrich, and hope it goes away. Some have said that about U.S. politicians when it comes to the nation’s $1 trillion deficit. The ominous-sounding combination of automatic spending cuts and tax hikes dubbed the “fiscal cliff,” a precipitous plan deadlocked politicians put in place last year, has the U.S. on edge. How do we feel standing at the edge of a cliff? Is there an urge to back away? To jump? To build a safe passage across the abyss? Set to go into effect on January 1, 2013, it remains to be seen what—if anything—Congress will do to change or delay these measures, and what longer-term solutions to tackle the deficit will be put forth.
Dr. Michael Hasenstab, Templeton Global Bond Fund portfolio manager and co-director of Franklin Templeton Fixed Income Group’s® International Bond Department, doesn’t prescribe legislative answers, but he can relate the fiscal challenges the U.S. faces to the experiences of a country with its own dramatic cliffs: Ireland.
Hasenstab’s key opinions:
- The U.S. will likely continue to “kick the can down the road,” and there could be a credit concern for the U.S. at some point.
- It’s possible some of the proposed (fiscal cliff) cuts will be postponed and some of the tax hikes will be moderated.
- At some point the U.S. is likely to have to pay the price for fiscal irresponsibility, and part of that price is higher interest rates.
- The Irish model could be an ideal prescription for problems in other parts of Europe. And hopefully, even the U.S. can look a little bit deeper into what the Irish have done.
- The commitment of the ECB to provide almost an unlimited amount of liquidity is helping prevent the Armageddon scenario in Europe.
If U.S. politicians fail to act before year-end, many economists predict the sweeping spending cuts and tax hikes scheduled to take place are likely to act as a weighty drag on growth, and could push the economy off the “cliff” into recession. Hasenstab believes there’s a growing risk right now to the ongoing political deadlock in the U.S.
“I think many politicians seem to be in denial and perhaps don’t understand the magnitude of the problem. Those politicians who recognize the fiscal concerns are unable to do anything about it. I don’t think the election is likely to change that; I think the U.S. will likely continue to kick the can down the road.
We can’t know for sure, but I believe politicians are likely to do what politicians do best, and that is to push the problem into the future. The good news with pushing the fiscal issues into the future is that we’re unlikely to face the severity of the fiscal cliff predicted by many. It’s possible some of the proposed cuts will be postponed and some of the tax hikes will be moderated. This wouldn’t solve the long-term fiscal issues, so we’d still have to face that, but in the short term it probably would help mitigate— at least somewhat— the negative growth consequences.
The problem is not going away and, at some point, we’re likely to have to pay the price of fiscal irresponsibility, and part of that price is higher interest rates. We don’t have to look too far, to Europe, to find out what could happen to Treasury yields if the market loses confidence in long-term fiscal programs—although I’m not saying it necessarily will.”
A European Prescription?
Of course, many countries in Europe are still working through debt problems, but one country there—Ireland—has provided an example of how it’s possible to tackle them. Ireland, which requested a bailout in 2010 and was considered one of the Eurozone “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) who got stuck in the 2008-2009 economic muck, has been working to clean things up.
“What’s been happening in Ireland is positive. The country, despite facing great adversity, continues to make progress on fiscal reform, and is increasingly getting recognition as a model for other countries. It can be summarized as a pro-growth and pro-austerity package, where growth is facilitated through structural reforms and competitiveness, and austerity is facilitated through fiscal responsibility, which Ireland has put forth and executed well. While there is still progress that needs to be made, I think the fact that Ireland was able to regain (international bond) market access after years of not being able to, is a clear sign that it is getting credit for a lot of the progress it has made. I believe the Irish model could be an ideal prescription for problems in the other parts of Europe. And hopefully, even the U.S. could look a little bit deeper into what the Irish have done and try to emulate some of those policies.”
Hasenstab recognizes that solutions—whether in the U.S. or in Europe—take time to work. He applauds the European Central Bank’s (ECB) latest support program, Outright Monetary Transactions (OMT).
“I think the ECB’s proposal to offer aid to countries in need and purchase bonds on a conditional basis is a fairly well- designed program. The commitment of the ECB to provide almost an unlimited amount of liquidity is helping prevent the Armageddon scenario. It provides a functionally almost unlimited firepower, and this was the war chest that was missing before. The commitment of the ECB’s balance sheet is of the scale that can address the issues, and the conditionality of the proposal appears quite healthy, unlike the U.S. Federal Reserve’s unlimited purchasing of U.S. Treasuries without any conditionality on fiscal responsibility. The proposals in Europe present some controls and demand reforms in exchange for help. This will help further the reforms that are absolutely critical for the countries that have become uncompetitive. I think the ECB and its role in crisis management deserves a fair amount of credit and has been a game changer.”
Hasenstab acknowledges that conditions in Europe will likely remain difficult for some time. But he has had continued faith that the Eurozone would not break apart. Besides Ireland, he still sees other opportunities in Europe, particularly in the less-leveraged economies in Central and Eastern Europe.
“We need to be realistic. In our view, conditions in Europe are going to be troubled. Deleveraging is painful, and growth is likely to be very weak, but that doesn’t equate to an Armageddon scenario. It looks to be a very difficult environment for growth, but the Eurozone should hold together. In my view, some of the biggest opportunities in Europe are outside of the Eurozone–in Central and Eastern Europe. These countries are benefiting from the massive quantitative easing that’s going on in the Eurozone; they are recipients of fairly large capital flows and at the same time these countries don’t face the massive deleveraging that is being experienced in many cases in the Eurozone.”
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