4 Questions to Understand the Fiscal Cliff

Judging by media coverage, the so-called "fiscal cliff" is the only thing driving the U.S. stock market these days. Unfortunately, a lot of the coverage is either alarmist, erroneous, or focused solely on the daily (or even hourly) micro-developments in the story. Here are four simple questions with answers I hope will help long-term investors frame the issues properly.

1. What is the fiscal cliff?
The "fiscal cliff" is, to use another metaphor, a perfect storm of tax increases and government spending reductions that are set to begin on Jan. 1, 2013. These changes stem from a number of sources, including:

  • The 2011 Budget Control Act, which put an end to last year's debt ceiling crisis. One of the provisions called for automatic across-the-board cuts in defense and discretionary spending if Congress failed to enact spending cuts voluntarily.
  • Expiration of the George W. Bush tax acts, which were extended once by President Barack Obama in 2010.
  • Expiration of the 2% Social Security payroll tax cut and federal unemployment benefits, both of which were extended by President Obama in 2012.

Without any countervailing action from lawmakers, the policy path we are now on would significantly reduce the budget deficit in 2013 -- but at great cost to the economy.

2. Why is it called a "cliff"?
The Congressional Budget Office estimates that if no action is taken to avoid the fiscal tightening from the combination of lower government spending and higher taxes, the U.S. economy will shrink by 0.5% next year on an inflation-adjusted basis. In many areas of ordinary life, a half-percent decline in some metric or quantity isn't terribly consequential; often, it will go completely unnoticed. If you have $2 in change in your pocket, you're unlikely to be concerned by the loss of a penny. A student who scores 100 on her first test won't panic if the next test comes back marked 99.5.

When it comes to the U.S. economy, however, the decline equates to recession and all the unpleasant things that go along with it. Let's get specific: According to the CBO, under that scenario, the unemployment rate would rise from its current level of 7.9% to 9.1% by the fourth quarter of next year. The last time the unemployment rate was at that level was in July 2011. The U.S. economy could effectively lose the benefit of nearly two and a half years' worth of improvement.

3. It's not really a cliff, though, is it?
Well, no. Federal Reserve Chairman Ben Bernanke coined the expression "fiscal cliff" in a Q&A session during his Semiannual Monetary Policy Report to Congress on Feb. 29, 2012. Bernanke chose it voluntarily to focus lawmakers on the risks associated with premature fiscal tightening, and it has become popular as shorthand for the damage that lawmakers' inaction could wreak on the economy. However, the metaphor is misleading in that it suggests an immediate, sharp, and irreversible drop-off in economic activity on Jan. 1. Think Wile E. Coyote running off the edge of a cliff and plunging into a canyon while chasing the Road Runner.

In reality, that's not what would happen here. For example, the CBO estimates I cited above assume that lawmakers do nothing whatsoever throughout 2013 to alter the current policy path. Instead of a coyote going off a cliff, think of a car without steering starting down a long slope toward a wall. The sooner the driver applies the brakes, the less damage the car takes when it car reaches the wall.

4. So if Congress and the White House act in time, we can avert any negative impact on the economy altogether?
Not so fast! There is plenty of anecdotal evidence that the fiscal cliff is already having an impact on companies' behavior, whether they be Dow Jones Industrial Average (DJINDICES: ^DJI  ) or S&P 500 (SNPINDEX: ^GSPC  ) components or smaller businesses across the country.

With the release of its Beige Book business survey last Wednesday, the Fed said that seven of its 12 districts reported "either slowing or outright contraction in manufacturing," with some respondents "[expressing] concern about the outlook for 2013, in part, due to the uncertainty regarding the outcome of the fiscal cliff."

Meanwhile, investment bank Goldman Sachs published what it calls its S&P 500 Beige Book at the beginning of November, according to which the fiscal cliff was one of the top three concerns cited by companies in their third-quarter earnings conference calls. Blue-chip names that referred specifically to fiscal-cliff-linked uncertainty as an impediment to planning include McDonald's (NYSE: MCD  ) , General Electric (NYSE: GE  ) , and JPMorgan Chase (NYSE: JPM  ) .

It's possible that companies are only deferring spending and investment and will make up for any shortfall attributable to the fiscal cliff once the issue is resolved. However, it's a reasonable assumption that the longer the issue remains outstanding, the greater the probability that some of its impact will be near-permanent as companies raise the risk premium they attach to all policy-related uncertainty. That assumption looks even more plausible if we consider that any fix will likely only be a prelude to a broader, more complex negotiation to achieve a U.S. fiscal position that is sustainable over the long term.

The bottom line
The Motley Fool wants to help investors understand enough about the fiscal cliff to recognize how significant it is in the context of a long-term investment strategy. This article kicks off a series of four articles -- published daily for this week -- that will examine different aspects of the fiscal cliff. Be sure to visit Fool.com tomorrow for part two of our series, in which we'll take a closer look at the cliff's impact on individuals.

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  • Report this Comment On December 04, 2012, at 5:25 PM, miteycasey wrote:

    Or companies could say it's no big deal and move on with business as usual.

    Businesses, and people, don't like uncertainty. Jan. 2 2013 we'll have certainty and we'll be on to the next non-issue.

  • Report this Comment On December 04, 2012, at 5:47 PM, ryanalexanderson wrote:

    > Businesses, and people, don't like uncertainty. Jan. 2 2013 we'll have certainty and we'll be on to the next non-issue.

    Extremely unlikely, sorry to say. Recent history suggests that the issue will be stop-gapped/postponed.

    Why address a problem when you can kick it down the road?

  • Report this Comment On December 04, 2012, at 5:56 PM, xetn wrote:

    All these comments overlook the huge impact facing business in the form of the giant tax related to Obamacare. Many are downsizing so as to be below the 50 full time employees and escape the tax.

    This will have a big impact on employment.

  • Report this Comment On December 04, 2012, at 5:59 PM, miteycasey wrote:

    And that's part of my point. By Jan. 2 we'll know the lay of the land and be able to move on to other things.

  • Report this Comment On December 04, 2012, at 6:00 PM, FinnMcCoolIRA wrote:

    "•The 2011 Budget Control Act, which put an end to last year's debt ceiling crisis. One of the provisions called for automatic across-the-board cuts in defense and discretionary spending if Congress failed to enact spending cuts voluntarily."

    OR/AT LEAST:

    Since Obama is the one doing the $5+ TRILLION in outrageous spending AND the proponent of irrational higher taxes, maybe, HE should be the one held responsible for needed 'modifications'.

    IT'S HIS 'FISCAL CLIFF'!

  • Report this Comment On December 04, 2012, at 6:45 PM, Jurobi wrote:

    Actually it no real big deal (except for the new taxes to support Obamacare). The "tax increase" restores the taxes to where they were before Bush took office. The expiration of the "payroll tax cut" pust social security taxes paid by individuals back to 6.2%, which the employers have continued to pay their 6.2%, so the Federal government will stop borrowing to make up for the 2% loss, increasing the time social security will be "solvent" at full benefits. And the budget cuts put government spending back to the levels around 2006-2007 under Bush. Note that the taxes and budget cuts reflect taxees and spending at times when the Federal government was runniing a much lower deficit, and may actually cause a near-balanced budget.

  • Report this Comment On December 04, 2012, at 6:50 PM, adiabatic wrote:

    From a deficit reduction perspective, the Fiscal Cliff is the best bet -- large cuts in spending AND large increases in revenue. This is a better deal than anything that Congress can come up with, since Obama will almost certainly cave and compromise away the tax increase. The dire predictions do not take into account the benefits of reduction in deficits. I'd say keep driving, the cliff is a scare tactic!

  • Report this Comment On December 04, 2012, at 7:22 PM, joansullivan wrote:

    Yes, free up those Grover Norquist handcuffs, by lowering taxes on the 90+% after the first of the year. Restore the good spending, e.g. on infrastructure, education and reduce defense spending and oil and farm subsidies after the first. The good spending should give a stimulus to our economy, which can only expand if funds flow more freely.

  • Report this Comment On December 04, 2012, at 7:49 PM, sciencedave wrote:

    The "fiscal cliff" reminds me of Y2K nonsense. The estimates of this prolonging a slow economy are just that: estimates. No one really knows. Chances are it will be a non- issue in 2013.

  • Report this Comment On December 04, 2012, at 8:19 PM, thedoge wrote:

    "Businesses, and people, don't like uncertainty." Anybody who can't handle uncertainty shouldn't be in business. Risk and uncertainty are part of the territory. Maybe too many companies have gotten too comfortable with the idea of being "too big to fail" and forgotten that the freer a market is, the more risky it is.

  • Report this Comment On December 04, 2012, at 9:09 PM, TopAustrianFool wrote:

    The Cliff is actually a good thing, because it reduces govt outlays which is money that govt takes from the real productive wealth creators in the economy and gives to wealth destructive spenders. Therefore, any GDP shrinking you see is due to current wealth destructing waste funded by govt.

    So although deflation will ensue sometime in the Spring of Summer, over time this leaves wealth creators with more money and the economy should grow permanent wealth creating jobs that need no subsidies from govt.

    The Cliff is a good thing, and it will happen sooner or later.

  • Report this Comment On December 04, 2012, at 9:53 PM, wjcoffman wrote:

    The American people don't care. Look at the latest election results.

    Disclosure: LONG freedom and the American way!

  • Report this Comment On December 04, 2012, at 10:20 PM, chris293 wrote:

    This cliff and all of the panics, repressions, depressions of the past 500 years can be based on the public fear it generates. How best to control people than to have them too worried or scare to take care of themselves and do right for for themselves and others.

    How can anyone or a business be confident if they don't know the rules or the taxes they will have from one day to the next? That's not a way to run the United States, or for that matter any truely free capitalist country.

    Some bad forms of governments and some types of controlling groups will encourage people to live in the past and not see and learn of the great progress, freedom to think and grow for themselves will bring. Confidence with courage, not superstition and fear is what makes the United States great.

  • Report this Comment On December 04, 2012, at 11:07 PM, RouteReflector wrote:

    @xetn: companies have been doing that for years anyway. That's nothing new and someone would be hard-pressed to argue it's a result of the ACA with any intellectual honesty.

    @FinnMcCoolIRA: congress proposes all spending and the President either approves or rejects it. The cliff, with its significant cuts and raises, was a bipartisan effort. Our fearless leaders, in an effort to avoid federal financial ruin, concocted a plan to ensure federal financial ruin if they couldn't come up with a compromise to avoid federal financial ruin. It was pure brilliance. (those last 2 sentences were written in sarcasm font)

    @ScienceDave: the Y2K issue was a legitimate issue, but it was fixable and was fixed, which is why it didn't cause problems. If it wasn't fixed it would have caused some pretty big hiccups. The same can be said for the Fiscal Cliff; it's just a matter of our elected leaders fixing it.

    My take: I'm particularly fearful of the across-the-board spending cuts, because contrary to the beliefs of many, government spending does actually create jobs. My job is directly attributable to federal government spending as I'm a contractor for a DoD agency.

    I provide a service to the government; the government pays my company; my company pays me; I pay taxes, buy food, buy gas, buy goods, etc. My job is put in immediate danger by the spending cuts included in the cliff.

    Do I think those spending cuts and tax raises need to happen? Yes, I do. However I believe, as I think most people do, that the changes should be phased in much more gradually over the course of a number of years.

  • Report this Comment On December 05, 2012, at 9:44 AM, LAVol wrote:

    I do not believe increasing tax rates will increase revenue. I believe individuals will spend more, create more jobs than gov't can, if the money is left in the private sector. The more jobs created, the more revenue, the less dependence on gov't handouts. You cannot tax your way out of a recession. Gov't = waste.

    On a related issue, I don't believe there should be any corporate income tax. Corporations don't pay taxes--consumers pay the tax when they purchase the goods and services of the corporation.

  • Report this Comment On December 05, 2012, at 10:29 AM, TMFGortok wrote:

    "My take: I'm particularly fearful of the across-the-board spending cuts, because contrary to the beliefs of many, government spending does actually create jobs. My job is directly attributable to federal government spending as I'm a contractor for a DoD agency."

    The money the government used to 'create' your job had to be taken from somewhere. It had to either be raised through taxes, inflation (printing money) or borrowing. That's why people say the government cannot create wealth; it is necessarily a zero sum game in the long run (someone will have to pay the piper for your job).

    Contrast that with a private sector job creator: The money invested in the business either came from the individual starting the business, or from a voluntary loan, and the person hiring is willing to hire because the act of hiring will make sure they can create more widgets. They create more widgets (and people buy them) and they make more money. The money allows them to reinvest in their business and pay their employees.

    Wealth was just created, all voluntarily.

    It does affect you, I admit -- but in a world where we didn't have the government borrowing/taxing/inflating to create your job, we'd necessarily have more wealth in our own pockets and in the pockets of our future generations -- and incidentally, if this happened writ large, there'd be no 'fiscal cliff' to be worried about, nor where there be a government debt to even facilitate such conversations.

    You'd still likely have a job; it'd just wouldn't be for the government; it'd be in the employ of someone who would be able to produce a good or service that other people would voluntarily purchase.

  • Report this Comment On December 05, 2012, at 12:10 PM, TopAustrianFool wrote:

    "You'd still likely have a job; it'd just wouldn't be for the government; it'd be in the employ of someone who would be able to produce a good or service that other people would voluntarily purchase."

    I agree, the reason a lot of people are employed by govt is because govt has distroyed their industries. An example is R&D in industry has been shrunk due to regulation and govt funding of science. So today most scientist have to work for the govt.

    If govt shrunk and deregulated these jobs wouldreturn to the private sector, and also would be subject to free market price system which allows one to know how useful is ones job to the overall economy.

  • Report this Comment On December 05, 2012, at 3:18 PM, FriedBrain wrote:

    "I agree, the reason a lot of people are employed by govt is because govt has distroyed their industries. An example is R&D in industry has been shrunk due to regulation and govt funding of science. So today most scientist have to work for the govt."

    @TopAustrianFool: say what? Government - either in this country or others - has always financed large-scale research that the private sector just couldn't touch.

    Columbus' trips to the New World? Funded by the Spanish Crown, because private enterprise couldn't take on the risk.

    The Moon shot? Funded by the US government, because the private sector didn't have an entity big enough to support it without help.

    Basic research into cancer? Funded by governments because there's no assurance of a payoff, which the private sector cares about A LOT.

    Or, how about the Manhattan Project?

    Government funds research like that because the risks are too great for the private sector to absorb.

    Now, let's talk about all of the opportunities that opened up TO the private sector once the uncertainty was reduced significantly ...

  • Report this Comment On December 05, 2012, at 3:27 PM, Hestheone wrote:

    How can anyone really believe that the criminals who run this country will allow defense spending to be cut?

  • Report this Comment On December 05, 2012, at 4:56 PM, TopAustrianFool wrote:

    "Columbus' trips to the New World? Funded by the Spanish Crown, because private enterprise couldn't take on the risk."

    Excuse me! The govt doesn't have any money! It takes it from wealth creators and gives it to a lot of useless research that no one funds because its worthless.

    Columbus' incentive to go east had to do with the price of spices due to the fall of the Mongol Empire trade routes which became close due to the panic of the Plague. The Spanish Crown funded Columbus trip with private money expropriated from individuals. Do you even have an idea of what Feudalism is?

    "The Moon shot? Funded by the US government, because the private sector didn't have an entity big enough to support it without help."

    You just made my point. Useless research. Once we proved to the USSR that we could put Nuclear Weapons out of their reach, we signed a treaty of Moon nonmilitarization. What a waste.

    "Or, how about the Manhattan Project?"

    Defense project from privately funded knowledge.

    "Government funds research like that because the risks are too great for the private sector to absorb."

    Govt funds research like that because it increases their control to have no competition.

    I never said that govt should not fund any research. I said that after Vannevar Bush's programs in the 40's, govt has destroyed private research by regulating it into oblivion and has therefore become the only monopoly in research.

  • Report this Comment On December 05, 2012, at 7:11 PM, RouteReflector wrote:

    Kind of ironic how people are posting on the internet about how government research doesn't lead to anything worthwhile.

  • Report this Comment On December 05, 2012, at 11:42 PM, Rayheem wrote:

    As Marc Rubio said, "We do not need new taxes, we need new tax payers". We will get new tax payers when we construct a balance of trade with other countries. One of the most valuable products we have exported in the past is military protection of oppressed peoples such as in Bosnia and Libyia. The United Nations should paying us for these services, however even this money would be coming from the United States. Maybe the fiscal cliff is a good thing after all. Or as Newt Gingrich said, it could become a series of descending foothills.

    By the way, the Y2K issue was never a legitimate issue for Apple's Macintosh since it used the full 32 bit word, whereas many PC"s were still using 16 bits.

  • Report this Comment On December 06, 2012, at 7:34 AM, TopAustrianFool wrote:

    "how government research doesn't lead to anything worthwhile."

    No one said this, what I said is that there is a lot of wasted dollars in govt R&D. I did not say all govt R&D money is a waste.

    Kind of ironic how people posting do not know how to read.

  • Report this Comment On December 06, 2012, at 8:28 AM, mikecart1 wrote:

    My only complaint is to find whoever originated the term 'fiscal cliff'. When it is mentioned among casual people and non-investors, they think it means we are all going to die or go broke or both. I wonder how much attention it would get if it was named for what it is, 2013 Tax Increases.

  • Report this Comment On December 06, 2012, at 10:39 AM, eltabor wrote:

    These republicans and tea baggers caused this mess with two unfunded wars and king george tax cuts and procrastinated their debt. Now when it is time for them to pay their bill, they refuse. This is silly, to hold the country up for ransom and john bonehead ought to be ashamed of himself. I hope the President doesn't give in to these loons. He is smarter than they are and I think he set this trap during the last debt ceiling crisis knowing he would be re-elected. As for me there is nothing I can do, but continue with daily life while the insane continue with the temper tantrums.

  • Report this Comment On December 06, 2012, at 1:43 PM, Rayheem wrote:

    Mikecart1, you said "My only complaint is to find whoever originated the term 'fiscal cliff".

    The above article answers your question.

    Alex Dumortier wrote:

    "3. It's not really a cliff, though, is it?

    Well, no. Federal Reserve Chairman Ben Bernanke coined the expression "fiscal cliff" in a Q&A session during his Semiannual Monetary Policy Report to Congress on Feb. 29, 2012"

  • Report this Comment On December 06, 2012, at 1:53 PM, mikecart1 wrote:

    Oh thanks Rayheem. Bernanke always causes problems lol.

  • Report this Comment On December 07, 2012, at 4:26 PM, olmant wrote:

    The problem is it only cuts Gov spending on 40% of gov spending on gov work/Military, but not a penny on entitlements and left wing spending of great money attempting to teach people (including me) to vote leftwing and get money through the Gov rather than learning to produce/work to sustain oneself.

  • Report this Comment On December 07, 2012, at 4:29 PM, lleach wrote:

    IMHO going off the cliff is the beginning of a good start to get the national debt the U.S. Socialists are amassign under control.

  • Report this Comment On December 07, 2012, at 4:51 PM, Lobo7Gris wrote:

    It is a fallacy to believe that increased consumer spending will revive the economy. The problem being that we make very little since the advent of "free trade" and the subsequent movement of virtually all manufacturing to low wage overseas areas. As an example take a trip to Target. They have one coffee pot for sale made in the U.S. The other ten or fifteen regardless of brand name are all made in China. Buying that Chinese made coffee pot will not create a single job in the U.S although it will in China where it is made if enough of a particular brand are bought. Other products? Check the labels and see how many made in the U.S. labels there are. I guarantee that you will find few if any

  • Report this Comment On December 07, 2012, at 8:52 PM, ceyhun28 wrote:

    Thank you Alex for this excellent article. Much more informative than any of the newspapers or financial TV channels.

    Since coming to a deal (or more likely a transient bandaid) before or after the holidays is almost certain I am more interested in Alex's fourth question :

    WHAT WILL HAPPEN AFTER A DEAL?

    How much impact will some of the tax increases have?

    Even if we avert a recession, will a measly 1-2% anemic growth of GDP can support a overbought market for long? Anyone??

  • Report this Comment On December 07, 2012, at 9:59 PM, Noshine wrote:

    If you want to argue over whether government or business is the better creator of jobs, productivity, and a stable economy, consider eliminating each individually and witness the economic impacts.

  • Report this Comment On December 08, 2012, at 1:27 PM, dadyer wrote:

    Mr. Dumortier leaves me wondering. His attempt to answer the question What is the Fiscal Cliff? seems rather paradoxical to me. He states "Without any countervailing action from lawmakers, the policy path we are now on would significantly reduce the budget deficit in 2013 -- but at great cost to the economy."

    He then uses the CBO to support the assertion. Yet, the CBO, with its static scoring fails miserably at most everything except providing justification to Congress for continuing the policies that have brought us to this non-existent "fiscal cliff" in the first place.

    So what is the purpose of parts 3 and 4 above? Part 3 addresses something that has just been demonstrated does not exist. Part 4 suggests that the very people responsible for the mess may be able to act "in time" to save us from the consequences?

    BTW: Great comments TopAustrianFool and TMFGortok!

  • Report this Comment On December 10, 2012, at 6:44 AM, xbwe3456 wrote:

    I have a 5th question concerning the physical cliff.

    As a beginning Foolish investor who may or may not experience personal gains or losses as a result of the physical cliff, would it be better to take a cash distribution from a 401k in 2012 or wait until 2013? As I understand it distributions composed of dividends and capital gains would be taxed at a higher rates in 2013 erasing realized gains. I believe higher taxes on individuals would impact the economy in this area as many "boomers" cash in retirement plans as they retire.

  • Report this Comment On December 10, 2012, at 12:56 PM, NoOracleHere wrote:

    When placed against the backdrop of the business cycle, I find it difficult to believe that the so called "fiscal cliff" will result in anything more than a slowing of the recovery, yet the recovery should continue unabated.

    The big fear being touted in the rhetoric is that the fiscal cliff will send us right back into recession. Yet I see no precedence of any real recession caused by such a thing. Recessions are almost always caused by the burst of an economic bubble of one kind or another. The recession of 2000/2001 was the pop of the internet bubble. The housing bubble together with the debt bubble caused the 2008/2009 recession. The fiscal cliff proposes no such bubble, and I don’t expect it will cause a recession. Slow the recovery? Perhaps. But I’m certainly not anxious to feed the next bubble.

    Alternatively, the fiscal cliff may just represent a return to sanity. It was a compromise effort of an insane congress who in 2001 and 2003 passed ridiculous tax cuts while starting up 2 wars on credit, and over the last 3 years has not even passed a budget.

    We have a real need to return to a sensible progressive tax structure. We also need to stop feeding speculation in all its many flavors. Most of the stimulus packages of the last 20 years or so did less to stimulate real economic activity and more to stimulate speculation. Wrong economy. When we stimulate, we need to make sure we are stimulating the productive/consumptive economy. This is where people are employed, and value is created. It would be far healthier to place disincentives on the speculative economy. Where was our tax revenue windfall when hedge funds properly configured made billions off of the losers in the 2008 financial crisis? (After all, some people made a killing betting against those bad debts.) Almost nonexistent – taxed at 15%, if at all. We have our incentives structured all wrong – rewarding those who rape the economy and penalizing those who work for a living and create value.

    Fiscal cliff? I say return to sanity.

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