Fiscal Cliff: If You Aren't Worried, Here's Why You Should Be

So when they all start using a term like “fiscal cliff” to describe the simultaneous onset of big tax increases and spending cuts in the United States scheduled for Jan. 1 -- a $720 billion bonanza -- it’s hard not to take notice.

Especially when going over the cliff, according to Capital Economics Senior U.S. Economist Paul Dales, could wipe out the recovery completely. And Barclays sees a 44 percent probability of this happening.

Indeed, the unknown -- the probabilities or possibilities -- is the X-factor, as there will likely be no visible effort to avoid the fiscal cliff until after the presidential election. In other words, Congress will have about seven weeks between Election Day and New Year’s in which to steer the economy away from a potentially devastating crisis.

What investors and companies hate most is uncertainty, said Andrew Wilkinson, chief economic strategist at Miller Tabak & Co. in New York.

Hence, as the cliff approaches, firms will start to postpone lumpy, hard-to-reverse hiring and spending decisions, weakening the economy before we even reach the edge.

When you are approaching a cliff, in a deep fog of uncertainty, you slow down, Ethan S. Harris, North American economist for Bank of America Merrill Lynch, wrote in a note. We expect people to wait until the spring, when the cliff is hopefully resolved, before making important commitments.

What Is The Fiscal Cliff?

The phrase was coined by Federal Reserve Chairman Ben Bernanke to describe the large spending cuts and tax increases that are scheduled to be automatically enacted at the start of 2013 unless Congress takes action. There are five major elements to the fiscal cliff:

• The expiration of the George W. Bush-era tax cuts and the end of the Alternative Minimum Tax fix. In 2001, 2003 and 2006, Congress passed a series of tax cuts that reduced rates on investment income, estates, gifts and earnings at all levels. Many of these cuts are set to expire on Dec. 31. If this occurs, families would be hit with an average tax increase of $3,000, according to the Tax Policy Center. Meanwhile, Congress has regularly extended the temporary Alternative Minimum Tax patch so that more than 20 million relatively middle-income households won't be subjected to a tax that was originally imposed to ensure that the wealthy paid their fair share.

• The Social Security payroll tax will pop back up to 6.2 percent from 4.2 percent on Dec. 31. Once the payroll tax holiday expires, a median-income household making $51,914 a year will have to pay an additional $1,038 into the system next year -- or about $87 a month.

• The expiration of extended unemployment compensation. Support for the jobless -- a higher maximum number of weeks the unemployed can collect benefits -- is set to expire at the end of this year. That will cut federal spending by about $26 billion between fiscal years 2012 and 2013.

• Big spending cuts. Billions of dollars of federal government spending reductions will go into effect automatically next year, a consequence of Congress's inability last summer to lower the deficit by at least $1.2 trillion over 10 years. In addition to slashing defense by 10 percent, about 8 percent will automatically be eliminated from non-defense discretionary programs, ranging from education to national parks. The Congressional Budget Office predicts such cuts will reduce federal spending by $65 billion between fiscal years 2012 and 2013.

• The doc fix. Reimbursements to doctors who treat Medicare patients will be trimmed significantly, which would lower spending by $11 billion.

Risk To The Economy

Economists and the CBO predict that the U.S. will almost certainly go into recession early next year if the expiring tax cuts and impending spending cuts take effect all at once. And this new recession, notes David Fiorenza, economics professor at the Villanova School of Business, would likely be “much more severe than the one that occurred a few years ago.”

According to a recently released CBO analysis, if the U.S. actually goes over the fiscal cliff, GDP would contract by 1.3 percent in the first half of 2013, before rebounding by 2.3 percent in the second half.

You can't have a recession like that without job losses, added Christopher Low, chief economist at FTN Financial in New York.

The unemployment rate would very likely return to the old high and maybe even push higher still, Low added. I wouldn't be surprised if we end up somewhere between 10 percent and 11 percent.

On the other hand, simply kicking this gigantic can down the road, which some economists estimate would lead to economic growth next year of 4.4 percent, wouldn’t sit favorably with Standard & Poor's and Moody's. The rating agencies would likely downgrade the U.S. government’s credit rating since Washington will have shown again that it is unable to tackle the country’s deficit. Without any fiscal tightening, more than $7 trillion could be added to the country's debt over 10 years.

No doubt the combination of rising interest rates, higher taxes, and fewer government services is distasteful to voters. Nevertheless, this is our future like it or not, said Albert Lu, managing director and chief portfolio manager of WB Advisors.

Taking our economic medicine sooner rather than later will undoubtedly trigger a recession but in time will give us the robust recovery we all desire while keeping consumer prices from running away, Lu added.

Will Congress Steer The Nation From The Fiscal Cliff?

Economists are split on this one.

Some say they can't imagine anything getting done until the Presidential election. From now until Nov. 6, the campaign cycle will likely exacerbate differences between the two parties. Thus it will be hard for any politician to signal to those across the aisle or to the markets that a compromise is possible.

House Speaker John Boehner recently said he would draw a line in the sand and insist on spending cuts greater than the debt limit increase.

Unfortunately, we are also going to be dealing with a lame duck Congress, said Rick Scott, senior managing director of L&S Advisors Inc.

Divisions within both the House and Senate will remain, regardless of who is inaugurated on Jan. 20, 2013, Ethan S. Harris, North American economist for Bank of America Merrill Lynch, wrote in a May 30 note.

Even if one party sweeps, the minority party will likely have enough votes (40) to slow or block legislation in the Senate. Quickly passing a budget plan early next year will be a challenge, Harris said.

Goldman's Alec Phillips, a political analyst and economist, figures that the only way Washington will avoid the fiscal cliff is if Obama wins the presidency and the current balance of power in Congress is maintained. With the status quo in place, there will be more motivation to get a deal worked out before Armageddon than after.

On the other hand, if Republicans win control of the Senate or the White House, the likelihood that Congress would enact a long-term extension of expiring tax cuts before year-end would be virtually nil, since Republicans would be in a better position to enact their preferred policies in early 2013.

Democrats in Congress might also prefer to let them take responsibility for these issues, since an increase in the debt limit is likely to be necessary at around the same time, and lawmakers of both parties would rather avoid responsibility for increasing the debt limit if possible, Phillips said in an April 4 note.

Some experts are more optimistic, however.

Politicians' bark is worse than their bite, Michael Hanson, senior U.S. economist for Bank of America Merrill Lynch, wrote in a May 4 note. Faced with a weak economy and financial markets, we would expect both sides to eventually capitulate.

One factor that may weaken Congress's motivation to make hard decisions is the hope that the Federal Reserve may offer temporary monetary fixes as a substitute for permanent fiscal reform. But, as Rick Scott, senior managing director at L&S Advisors Inc., put it: I'm not sure it (the Fed) has got that many arrows left in its quiver.”

Is The Cliff-Diving Scenario Priced In?

Analysts say there is strong circumstantial evidence that the market does not understand the full dimensions of the fiscal cliff and therefore most of the risk is not yet priced in.

Scott, of L&S Advisors, recalled that during last summer's debt ceiling showdown many market participants said that the possibility of no agreement before the 11th hour was accounted for by the equities and bond bourses.

But lo and behold, when it finally happened, we had a pretty severe correction, Scott said.

Indeed, even with the recent declines in the stock market – the S&P 500 lost about 11 percent in May before it recouped roughly 70 percent of that loss in June -- stocks are still about 20 percent above lows of last October.

If the fiscal cliff was on anyone’s mind, Scott said, you could easily be down another 12 percent.”

Is There Money To Be Made?

Short-term investors may be able to take advantage of all the maneuvering that is likely to go on between now and when the edge of the cliff is reached. For example, if the situation gets dire and no agreement seems possible -- or even if over the next few months the job market remains slow and the euro zone’s troubles continue -- the Fed may put money into circulation through quantitative easing (buying bonds to inject dollars into the economy).

Opportunistic investors could ride the increase in market sentiment ... for a month or two, said L&S Advisors Inc. analyst David Soroudi, since perceptions don't always equal reality and the market would probably react positively to the announcement of the easing.

However, Soroudi warned that the market will soon realize that the quantitative easing hasn't really accomplished anything and would correct itself.

As for Treasury bondholders, Lu advises against long duration bond-holding because he believes that interest rates are bound to rise from their rock-bottom perch today.

We don't want to be hurt when interest rates adjust, Lu said. We are uncomfortable with being exposed to anything longer than three years.

Sounds like reasonable advice; if only these were reasonable times. Because if the fiscal cliff is actually reached -- and then breached -- even the smartest recommendations won’t keep virtually every critical facet of the economy, neither the markets, employers, employees, retailers and manufacturers, nor anyone else, from taking collateral damage.