Watch Out for the Cliff!

For the better part of a year, we at the Risk Integration Strategy Council (RISC) have been advising members on how their peers are bracing for the potential impact that the European sovereign debt crisis could have on the U.S. economy. However, RISC members have now shifted their focus, and angst about the fast-approaching “Fiscal Cliff” seems to be displacing European concerns as the primary risk to businesses and the American economy as a whole. These concerns are taking place beyond the walls of the RISC community as well. Morgan Stanley recently warned clients that concerns about the Fiscal Cliff are reaching new heights across a wide range of industries, with reductions beginning to occur in business orders and hiring among other areas.

The Nitty Gritty

While most RISC members have certainly heard of the Fiscal Cliff, some members do ask us what exactly makes up the “cliff.” At a high level, approximately two thirds ($399 billion) of the fiscal cliff will come from tax increases currently scheduled, while the spending cuts scheduled to take place in 2013 would total $103 billion. The looming changes include the expiration of the Bush-era tax cuts and nearly $1 trillion of cuts in defense and non-defense spending mandated by the Super Committee’s failure to come to a deficit reduction agreement.

Wall Street economists predict the impact to GDP growth as a result of these simultaneous changes could reach as high as 5%. This could drive us into negative GDP growth territory and potentially a recession. However, if Congress were to cancel all the tax increases and spending cuts, they would add more than $5 trillion to the national debt over a decade and likely invite further credit downgrades. A significant negative impact to GDP growth could also fuel fears of a double-dip recession. This could lead to a decrease in consumer spending and a further reduction in public and private investment.

Some say the United States is risking a fiscal crisis before new legislative measures go into effect on 1 January 2013. Given the recent weakness in the economy, many analysts are saying that the tax increases and spending cuts set to go into effect at the end of the year have already begun to cause companies to take their feet off the gas, reduce investments and put a hold on hiring plans. This aligns with what we have been hearing from RISC members and was echoed by Federal Reserve Chairman Ben Bernanke recently when he said the “recovery could be endangered by the confluence of tax increases and spending reductions that will take effect early next year if no legislative action is taken.”

What if Congress Punts?
Many political pundits believe that Congress will come back after the November elections and use the lame duck session to simply kick the can down the road. This would extend current law by putting off the decisions on the scheduled tax increases and spending cuts for another day. However, Chairman Bernanke has warned that if Congress fails to act, the economy could experience a repeat of last summer’s environment, when financial markets took a tumble amid uncertainty over whether Congress would raise the nation’s debt limit. Bernanke said, “Doing so earlier rather than later would help reduce uncertainty and boost household and business confidence… just delaying everything, just saying we’re not going to do it, put it off for another year, I think would be a very bad outcome.”

What Can You Do?
While many RISC members have told us that they are becoming increasingly concerned that the tax increases and spending cuts could have a significant impact on their organizations, few companies have taken any significant steps to mitigate or prepare for this risk. A recent CEB survey revealed that 80% of companies are not prepared for the impact of the approaching budget cuts.

With the US economy on the verge of feeling the repercussions of such a serious risk, RISC members must plan for different scenarios to think about how they would react to the potential impact of the Fiscal Cliff. When building out these possible scenarios, we at the risk council believe it is important to make the scenario planning process less complicated by focusing on only two or three plausible scenarios and keeping in mind five key criteria:

1. Plausibility—Selected scenarios must be logical, falling within the limits of what might conceivably occur.
2. Differentiation—Scenarios should be structurally different to avoid repetition or slight variation of a single case.
3. Consistency—Scenarios must be internally consistent; the combination of the scenario’s logics must not have any intrinsic inconsistencies that would undermine its credibility.
4. Decision-Making Utility—Individual scenarios, and all the scenarios as a set, should contribute specific insights into the decision on which the scenario planning process is focused.
5. Challenge—Scenarios should challenge the organization’s conventional wisdom about the future.

While it is important to map out possible scenarios, it is equally important to do everything you can to mitigate the risk before it is too late. Honeywell CEO David Cote recently laid out five things executives can do to put pressure on elected officials to address the mounting U.S. debt problems. This advice can also be applied to the ‘Fiscal Cliff.” Cote’s advice:

• Bring up the issue at every discussion with a politician.
• Bring it up in every external speech.
• Educate your employees and encourage them to contact their congressional representatives.
• Advocate for the Debt Debate.
• Support the Campaign to Fix the Debt, a bipartisan group designed to push elected officials to work together to solve the nation’s fiscal challenges. Note that Cote is a member of the Steering Committee for the Fix the Debt Campaign.

Action Steps for RISC Members

• Review our quarterly Emerging Risk Report and Monitor to learn how other companies are preparing for the Fiscal Cliff and to stay abreast of the other over-the-horizon risks that could impact your company.
• Learn how one member company assesses the impact of potential disruption scenarios on key management decisions.
• Review how one company uses an early warning system to identify significant shifts in the business environment.