The Fiscal Cliff. Hype or Hysteria?

| December 2, 2012 | 0 Comments

Last month I tried to show how Americans are both unclear and conflicted about what our federal government spends its revenues on and how much ought to be spent on those things. I tried to show that We The People want our government to spend more money on security and services than we are willing to pay for in taxes. More importantly, no politician has stood up and told us we can’t have low taxes and high benefits yet, either. In fact, many have campaigned on a promise of preserving benefits while cutting taxes. I know, shocking.

The “Fiscal Cliff” you’ve been hearing so much about is largely a result of this dichotomy. In late 2009, to help sustain our economic recovery, the Bush tax cuts were extended through 2012. During the debt ceiling debacle in the summer of 2011, Congress agreed to cut spending to the tune of about $120 billion per year for ten years, the first installment of which kicks in on January 1, 2013. In fact, there are several tax and spending policies that go into effect or expire on January 1, 2013. When you add them all together, you get a planned deficit reduction of over three percent of Gross Domestic Product (GDP). On the surface, this sounds pretty good.

The problem is that the economy is only growing at about two percent annually, so cutting three percent off the top virtually guarantees a new recession in 2013. The reason for this is that every dollar spent by the federal government is someone’s income, and a lot of the dollars collected from new tax revenues would have been someone’s spending.

Suppose the economy is about $16 trillion per year. Suppose also that government spending is about 25 percent of that number, or $4 trillion per year. But tax collections are only about $2.4 trillion. That means that about $1.6 trillion would be borrowed from somewhere else. Now remember, that extra $1.6 trillion supports a LOT of jobs. One rule of thumb suggests that every one percent of GDP equates to roughly 700,000 jobs. When the government spends money it doesn’t have, it is adding to the economy today. Of course, this isn’t free. Those borrowed dollars have to be paid back eventually.

Now, if spending was reduced gradually, and taxes were raised gradually, we could adjust to the changes over time. The real risk of the “fiscal cliff” is not so much the amounts as it is the timing. Raising taxes and cutting spending by so much so quickly could be a serious mistake, especially when the economy is so weak.

So, what are the possibilities? Remember that all of these changes will happen if Congress does nothing. They must act to fix this problem.

One possibility is that they come up with a small deal that temporarily suspends the spending cuts and tax hikes and puts the problem off a few months. Since there are only a few legislative work days left before year-end, this would give them more time to negotiate a compromise. While this could be viewed by markets as yet another failure to make tough choices, this seems to be the most likely outcome based on what I’ve read, and would at least be progress.

Another scenario is that Congress and the President can’t agree on a solution. While stock markets would probably react very badly in the short-term, it might not be as bad as it sounds. The tax and spending changes won’t be felt immediately, and because of the no new tax pledges taken by most Republicans, it will actually be easier for them to compromise in 2013 than in 2012.

A third possibility is that they are able to craft a ‘Grand Bargain’ that cuts spending and adjusts the tax code before year-end. While there are several outlines of such a bargain available, this outcome seems highly unlikely because there is so little time left to craft a deal. Still, a large bargain, even if we go ‘over the cliff’ first, could remove a LOT of uncertainty from the markets, and could be seen as very beneficial. At least until the next crisis erupts.

This column is prepared by Rick Brooks, CFA, CFP®. Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Rick can be reached at (858) 755-5166, or by email at Rick and his family live in Mission Hills.

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