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What the Fiscal Cliff Looks Like

If you haven't already heard the phrase "fiscal cliff," get used to it. You'll be hearing a lot about it over the next six months.

One of the most important but unknown facts about the federal government's massive budget deficit is how easy it is to fix. If Congress and the president do nothing and let all current laws play out as they're written on the books, the United States does not have a budget problem. At all.

The problem is that it requires a few things to happen:

  • All of the Bush tax cuts need to expire on Jan. 1, 2013, as they're currently set to.
  • A huge scheduled cut in Medicare payments to doctors needs to occur. This has been on the books since 1997, but is temporarily patched up through the so-called "doc fix."
  • Spending cuts mandated by last year's debt-ceiling deal have to actually happen.

The bigger problem is that no one -- not conservative politicians or liberal politicians or conservative economists or liberal economists -- wants to see all of that happen, especially at once. One group says the tax hikes will whack the economy while it's still weak and unemployment will rise. The other says spending cuts will whack the economy while it's still weak and un employment will rise. Both are probably right.

If Washington can't agree on what to do and all three policies play out as they're currently on the books, we hit the fiscal cliff on Jan. 1, 2013. If the policies are extended, we get a fairly smooth path:

Source: Congressional Budget Office.

Here's what Federal Reserve chairman Ben Bernanke had to say about the fiscal cliff during a press conference last month:

I think it's very important to say that if no action were to be taken by the fiscal authorities, the size of the fiscal cliff is such that there's, I think, absolutely no chance that the Federal Reserve could or would have any ability whatsoever to offset that effect on the economy. So as I have said many times before, it's imperative for Congress to give us a fiscal policy that achieves two principal objectives. The first is, of course, to achieve fiscal sustainability over the longer term; that is critical, and that's something that needs to be addressed. At the same time, I think that can be done in a way that doesn't endanger the short-term recovery of the economy. And I am concerned that if all the tax increases and spending cuts that are associated with the current law and which would take place -- absent any congressional action -- were to occur on January 1st, that that would be a significant risk to the recovery. So I'm looking and hoping that Congress will take actions that will address both sides of that-- both requirements of a good fiscal policy.

Will Washington be able to strike a deal, some compromise between the cliff and the extended deficits? Hard to say -- especially in an election year.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (8) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 17, 2012, at 12:01 PM, prginww wrote:

    I'm all for diving off this cliff.

  • Report this Comment On May 17, 2012, at 4:59 PM, prginww wrote:

    me two

  • Report this Comment On May 17, 2012, at 5:16 PM, prginww wrote:

    <rant>Oh, come on Ben. We can just print some more money couldn't we? That was your solution before and seems to have been the FED's solution to every economic recession since 1972. Hey, maybe we can drive our debt-to-GDP ratio to 140% and then declare bankruptcy. Then rob the Medicare and Social Security Trust Funds both at the same time. Then, right after, people of the U.S. will be hit by either stagflation or hyperinflation. Then those with gold, guns, food, and shelter will laugh at those that put "money" in their savings accounts, CDs, and Treasury securities. I'm with Seth on this one, lets drive the car off the proverbial "fiscal cliff" because if you buy and pay for everything on credit, eventually, the creditors are going to want their money back. You think Bernie Madoff's $50 billion Ponzi scheme was bad, try the U.S.'s $15.5 trillion Ponzi scheme. Like the Romans before us, the day of reckoning for the U.S.'s government spending in lagresse on "interventions", tax cuts, stimulus plans, corporate welfare, and subsidies is upon the U.S.</rant>

    In all seriousness, it is massive debts and lagresse spending that destroys republics and democracies, not bombs.

  • Report this Comment On May 17, 2012, at 5:56 PM, prginww wrote:

    The solution is clear, legal and easy.

    Enable the IRS to collect all the taxes due!

    That'd more than equal the deficit for the year.

    The legislatures keep reducing the IRS funding, despite clear evidence that every IRS-auditor dollar spent pays $20 or more back.

    The reagan tax cuts must lapse to begin to slow the growing disparity between the rich and poor.

    We suffer civil unrest when that ratio gets too large,

    and civil unrest is wildly expensive, at least.

  • Report this Comment On May 17, 2012, at 6:12 PM, prginww wrote:

    We have a serious spending problem in this country. If we're depending on borrowed money for hold up the recovery, then we are in a world of hurt as activity that comes from borrowed money isn't "real" in the sense that the music has to stop at some point. There's just a huge conflict of interest between congress and the people. Congress doesn't seem to want to cut spending because it hurts their political self interest (usually). So congress just continues to increase spending and burdens the population with a debtload that will never be repaid. Awesome. I wonder what % of revenues will go towards servicing debt in 5 years. We need austerity!

  • Report this Comment On May 18, 2012, at 12:24 PM, prginww wrote:

    Morgan Housel concisely and compellingly described a clear solution to the government's immediate deficit problem. He also said that the likely outcome, if all the elements of this solution were implemented, would "whack the economy while it's still weak and unemployment will rise." The quote from Bernanke assumes this outcome, and further says, "I think that (fiscal sustainability over the longer term) can be done in a way that doesn't endanger the short-term recovery of the economy."

    I believe both of these guys.

    There are no simple nor easy solutions here. Deep and careless cuts to military and safety net programs will weaken America's strategic (and economic) position in the world, and exacerbate economic suffering and the ongoing "hollowing out of the middle class", stopping the recovery in its tracks.

    Careless tax revenue enhancement policies will likewise suffocate the recovery.

    Bernanke advocates a "middle way". This kind of approach,possible only if the congress can free itself from its enslavement to the moneyed interests and its own dogmatisms, is the only one I can see that can save us from eventual economic and social chaos.

    Unleashing IRS to recover "all" of the undoubtedly vast sums of tax revenue evaded is a noble goal and might theoretically eliminate the deficit for a year or two, but then we're back in the frying pan. It's worth doing, but Congress keeps IRS on a very short leash, and too many wealthy contributors would be affected.

    Straightforward austerity should work eventually. But it's effects would stop the recovery in its tracks. There would be massive additional job losses in the military industrial sector, as well as in government funded spending of all kinds -- infrastructure, education, research, safety forces. The safety net would be massively reduced causing widespread hunger and hopelessness in America. Since consumer spending is somewhere between 60% and 70% of the entire economy, the economy would contract spasmodically. Civil unrest would become an ubiquitous and constant fact of life here. The stock market would certainly collapse. Serious precious metals accumulators could probably ride this out, even thrive temporarily. But But how many Fools would really enjoy living in a guns and gold America? Only a few, I think.

    The middle way, in my opinion, as frustrating and boring as feels (to me as well) is the only sustainable, responsible way.

  • Report this Comment On May 21, 2012, at 7:44 PM, prginww wrote:

    Congress will manage to find a solution worse than either of these alternatives.

    These are the people who couldn't decide on whether or not they should allow the US to go into default.

  • Report this Comment On May 30, 2012, at 11:22 PM, prginww wrote:

    I imagine the same things were said by Greeks once upon a time. But it's hard to wean the masses off the government teat.

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