Fiscal Cliff… What’s That?

Back in August of last year, a politically divided government which borrows more than $1 Trillion every year just to pay its bills was faced with a ceiling on its ability to borrow. The disputants side‐stepped a default by passing a statute they labeled the Budget Control Act of 2011. It contains provisions to raise taxes on January 1, 2013 by an estimated 20% and to automatically cut spending on most government‐sponsored activities at the same time, all in an effort to begin shrinking the annual deficit and at least move in the direction of fiscal health.

The Budget Control Act adds a bit of drama to New Year’s Day 2013, and media are making the most of it! This sudden and rather radical set of changes, while perhaps a turn for the better in the nation’s long‐term outlook, could plunge us “over the cliff” into another recession before we’ve recovered from the last one. Of course this has been known for over a year; did investors just start to worry about it when election results were in? Your guess is as good as anyone’s, but it may be that traders had bid up stocks, hoping for a shift in the political climate that might favor a more rational solution to the fiscal cliff. They may have been discouraged when the election results trumpeted “no change”. What now?

View From 30,000 ft.

The debt/deficit problem behind all the political theatrics is real and it is serious. But it’s been 40 years in the making; over two generations, we’ve enjoyed a culture of living beyond our means with government footing much of the bill. We won’t see that transformed in two months, or probably even in two years. There is no painless way out of the situation. It’s “Pay me now or pay me (more) later”. Creating the fiscal cliff was a desperate effort to buy time for a more reasoned solution… but nobody made good use of the time. So here we are again.

If we do not begin soon to eliminate the deficits and reduce our national debt as a percentage of GDP, the problem will get worse until it ends either in a sovereign default and a high unemployment depression, or in a chaotic era of hyperinflation. Neither end‐game is bullish for business or for stocks!

Can we solve the problem by “growing our way out of it”? Highly unlikely, for the simple reason that economic growth proceeds from savings and investment... not from government programs that divert money from the risk‐taking, innovative, jobs‐producing private sector. Not from government programs that punish saving and with 0% interest rates, currency abuse and rising taxes.

What Can “They” Do?

It’s conceivable, though barely, that the Executive and Legislative branches will agree on a plan to change the fiscal momentum without killing the golden goose. The trouble is we have elections every two years, and it’s hard to run for political office by saying to the electorate, “Please re‐hire me because I want to increase the taxes you pay and reduce (fill in whatever benefit you like… green jobs, defense jobs, medical treatment, unemployment pay & retirement benefits).”

Remember that old line about “a camel is a horse designed by a committee?” John Mauldin says he has a terrible feeling that we are all passengers on a ship-of‐state run by not one but many committees who are all in over their heads.

Perhaps the most powerful “committee” of all during this period of financial stress is the Federal Reserve. They are committed to the belief that consumption drives economic growth. To make the economy grow, they say, the government can just put money in the hands of people who will spend it and that will cause manufacturers to hire and then more people will have money, blah, blah, blah. It is the big Keynesian myth that money is money and it doesn’t matter if you earn it, borrow it or print it. Understandably, it is a very popular theory! It is a solution without cost; “a free lunch”. Right!