In the famous 1955 movie Rebel Without a Cause, troubled high school student Jim Stark (played by James Dean) winds up playing a game of chicken with his classmates. The game is played as two teenage boys drive stolen cars toward a cliff. The first one to jump out of his car "chickens out," losing the game. Jim Stark jumps first, but his competitor gets his jacket stuck on the gear shift, is unable to jump out of the car and ends up going over the cliff to his doom. I cannot say that he won that game.

The U.S. economy is at risk of driving, so to speak, over a "fiscal cliff " starting January 1, 2013, an event that threatens to wreck the economy. The fiscal cliff got its name because under current law, there will be a massive and rapid tightening of fiscal policy in January unless Congress and the president agree to change the law before then. There are fewer than five months to avoid going over this cliff.

It is an election year, and Democrats and Republicans are locked in a battle royale as the Democrats aim to take back the House of Representatives while the Republicans aim to take back the Senate and White House. Each party has very particular and different proposals about what kind of adjustments should be made, or not made, to taxes and spending. Neither party wants the U.S. to go over the fiscal cliff, but election-year politics are not congenial to the type of political compromise necessary for a divided government to change the law. And so the political parties are acting much like the teenage boys in the movie, determined to be brave and strong and insistent that the other party make the concessions necessary to avoid going off the cliff. It seems unfortunate that current US politics resembles a dangerous game played by juvenile delinquents, but I believe that is what we have reached. In politics, as in the movie, the game might not end well.

If the U.S. economy goes over the fiscal cliff, the impact could be huge. The economy would probably slip back into recession, and with the unemployment rate currently close to 8%, the US can little afford another significant rise in unemployment. Going over the cliff could have profound-and not entirely predictable-consequences for the stock market, Treasury and corporate bond yields, commodity prices, and the U.S. dollar.

Below, I give the details about policies that contributed to the current predicament, what exactly the fiscal cliff is, what going off the fiscal cliff could do, and how the government may address the risk. To quote an old Russian proverb, "We should hope for the best but prepare for the worst."

How Did We Get Here?
The largest part of the fiscal cliff is the so-called Bush tax cuts, which were created by two pieces of legislation, called the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). These acts cut income tax rates, created new tax credits, raised certain tax exemptions, expanded depreciation allowances, restricted the Alternative Minimum Tax (AMT), and reduced estate taxes.

EGTRRA was signed into law by President Bush on June 7, 2001, as a fiscal response to the "tech wreck" that began in 2000 and pushed the U.S. economy into recession in early 2001. It was a sweeping piece of tax legislation that lowered income tax rates, revised exemptions and credits to reduce the "marriage penalty," phased out the estate tax, and extended and simplified retirement and savings plans.

The most notable feature of the tax law was a multi-year reduction in tax rates for each income tax bracket. In particular, by 2006 the 28% bracket would be lowered to 25%, the 31% bracket would be lowered to 28%, the 36% bracket would be lowered to 33%, and the 39.6% bracket would be lowered to 35%. The 15% tax bracket was left alone, but a new 10% bracket was created for low-income tax filers, and the 15% bracket's lower-income threshold was indexed to the new 10% bracket. To address the so-called marriage penalty in the income tax, EGTRRA raised the standard deduction for married couples filing jointly. Additionally, EGTRRA increased the per-child tax credit and the tax credit for spending on dependent child care, and phased out limits on itemized deductions and personal exemptions for higher-income taxpayers. The law expanded and simplified the rules for retirement plans (such as Individual Retirement Accounts) and for educational savings accounts (called 529 plans). Finally, the law gradually reduced the estate tax, eliminating it entirely in 2010.

It may seem odd that EGTRRA was set to expire in its entirety at the end of 2010, but Congressional budgetary rules impose a time limit on tax changes.

The recession of 2001 was one of the shortest and mildest in US history, but the recovery was relatively sluggish. The Federal Reserve Board (the Fed) eased to promote a better recovery, pushing its federal funds rate down to 1.00%, which helped start the housing boom. President Bush also requested another round of tax stimulus to boost the recovery, and Congress delivered. JGTRRA was signed into law by the president on May 28, 2003.