December 05, 2012

The Fiscal Cliff

Credit: papaiga2008
In recent weeks, there have been a lot of people talking about a little something called the “Fiscal Cliff.” Some people seem to be worrying a great deal about it; other people don’t think it’s that big of a deal. I’ve had several friends and readers of this blog ask me about it, so today I thought we’d take a look at this so-called “Fiscal Cliff” our country is scheduled to fall off of on January 1, 2013.

The “Fiscal Cliff” gets its name because of the tremendous tax increases and spending cuts that are currently scheduled to happen all at the same time: the beginning of 2013. Some compare the immediate effect of these substantial tax increases and large spending cuts to jumping off a cliff. Personally, I think it's a better comparison to imagine yourself sitting by the side of a tranquil pool watching a hippopotamus on the diving board that is going to jump when the clock strikes midnight on New Year’s Eve.

This hippopotamus is made up of tax increases and spending cuts. The scheduled tax increases include:

The second part of the hippopotamus is the automatic spending cuts that are scheduled to take place because Congress failed to reach a debt-reduction deal in August of 2011. These cuts will eliminate $1.2 trillion in projected federal spending over ten years, with about half the cuts coming from the defense budget and about half the cuts coming from other government programs like education, air travel safety, and food inspection. Discretionary spending limits are also supposed to be formally capped.

Before we talk about how we get the hippo off the diving board, let’s take a minute to figure out how the hippo got there in the first place. From an economist’s standpoint, when a country’s economy is slowing, or not growing at a fast enough pace, its government can do two things to try to encourage growth: cut taxes and/or spend more. The theory behind cutting taxes is that individuals will have more money to spend in the economy if they owe less in taxes, which will stimulate the economy. The theory behind the government investing more money into the economy is that the increased spending will lead to more jobs, more products, and new growth that will get the economy moving again, and eventually the revenue generated will be worth the government’s initial investment. Our government has tried both of these option in recent years, and people will argue over the results, but either way, less tax revenue and more government spending has caused our national debt to skyrocket.

The funny (or not-so-funny) thing about the “Fiscal Cliff” is that our leaders purposefully scheduled these tax cuts to expire eventually and knew our government could not sustain its recent spending sprees when they provided stimulus. They were trying to do what they could to get our slowly-growing economy going again, but they really can’t afford to try much longer. What I mean, is that the hippopotamus represents the conundrum our government now faces: if they keep the tax cuts and keep on spending, our national debt could turn into a national security issue, but if they allow taxes to return to their previous norms and cut their spending, our economy could slow or even contract.

The “Fiscal Cliff’ is the scenario where Congress does nothing and allows the scheduled tax increases and spending cuts to occur. Essentially, the hippo jumps on New Year’s Eve. Sure, the impact on the economy could be dramatic, but I truly believe the tax increases and spending decreases need to happen to fix our national debt problem. If Congress does nothing and the hippo jumps, it is surgery by chainsaw, so to speak, but it is surgery we need. Some politicians, economists, and people are actually rooting for this to happen.

If Congress does act, other scenarios such as “Fiscal Ramps,” “Fiscal Ladders,” and “Fiscal Ledges” are out there. Under these proposals, some of the tax increases and spending cuts will go into effect, but not all fully or all at once. The theory is that these options would begin to address our national debt issues, but could avoid a possibly huge negative splash in our still slowly-growing economy. Under these scenarios, the hippo is essentially off the diving board and gently getting in the shallow end. Some politicians, economists, and people are actually rooting for this to happen.

I, nor anyone else, know what Congress is going to do (or not do), but I do know our national debt situation is as serious of an issue as our still slowly-growing economy. I don’t know what the short-term impact will be if the “Fiscal Cliff” scenario plays out, but I do know it will finally address some of our nation’s long-term concerns. The short-term impact will be less severe if a slower-instituted series of fiscal reforms is adopted in the next few weeks, but I don’t know how well it will address our nation’s long-term budget deficit. I do, however, believe that the longer Congress and our leaders remain indecisive, the more volatile markets, businesses, and individuals will become with anticipation.

So, how do I tell you all of this and still sleep? Easy - NyQuil. Seriously though, the important thing to remember is that, even if a hippopotamus jumps into a pool, the water will eventually settle. No matter how, if our country takes steps to reform its budget and lower our national debt, our country and our economy will be stronger in the long-term. As an investor and an American, I’m more interested in the long-term.


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