Stock market wild card in 'cliff' talks

Traders work at the New York Stock Exchange

Traders work at the New York Stock Exchange on Monday. If no budget compromise is reached, the reaction could be a panicky sell-off. (Dec. 10, 2012) (Credit: Getty)

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The stock market's unpredictability is perhaps the biggest wild card in the political showdown over the "fiscal cliff."

Congress and the White House can significantly soften the initial impact of the fiscal cliff even if they fail to reach a compromise by Dec. 31. But they cannot control the financial markets' reaction, which possibly could be a panicky sell-off that triggers economic reversals worldwide.

President Barack Obama's re-election gives him a strong negotiating hand, as Republicans are increasingly acknowledging. And some Democrats are willing to let the Dec. 31 deadline pass, because a rash of broad-based tax hikes would pressure Republicans to give more ground in renewed deficit-reduction negotiations.

A chief fear for Obama's supporters, however, is that Wall Street would be so disgusted or dismayed that stocks would plummet before lawmakers could prove their newfound willingness to mitigate the fiscal cliff's harshest measures, including deep, across-the-board spending cuts that Defense Secretary Leon Panetta says could significantly damage the nation's military posture.

The cliff's recipe of major tax hikes and spending cuts can actually be a gentle slope, because the policy changes would be phased in over time. Washington insiders say Congress and the White House would move quickly in January or February to undo many, but not all, of the tax hikes and spending cuts.

Financial markets, however, respond to emotion as well as to research, reason and promises. If New Year's headlines scream "Negotiations Collapse," an emotional sell-off could threaten the president's hopes for continued economic recovery in his second term, even if Republicans receive most of the blame for the impasse.

So far, the stock markets have stayed calm. The Standard & Poor's 500 index is up almost 13 percent for the year. That might be because investors agree a temporary trip over the cliff wouldn't be too harmful.

Or, it's possible that investors view the most pessimistic tones surrounding the fiscal cliff talks as posturing that will give way to a last-minute deal.

Rep. George Miller (D-Calif.), who has served in Congress for 37 years, highlighted the risks in a lack of communication: "Let's not pretend the markets fully understand the politicians, or the politicians fully understand the markets."

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