The Fiscal Cliff Explained

... and the Real Problem Behind It

If you've been listening to the news, you've heard a lot about The Fiscal Cliff.  So, what is it?  And, what does it mean to you?
 

While already facing a very weak US and global economy and high unemployment, the Federal Government, meaning the President and Congress, have caused a whole series of truly massive economic policy changes to occur on one particular day - New Year's Day 2013.  In general, the changes fall into two categories:  Large tax increases and dramatic government spending cuts.  The tax increases will have impacts across all segments of the economy -- not just the rich.  They include the expiration of the so-called Bush Tax Cuts on everyone (this will impact most tax-paying Americans), the expiration of Obama's temporary 2% cut in Social Security taxes on everyone (people with a job) and the lack of relief from the "Alternative Minimum Tax" -- which will now apply to 26 million American household.  (The AMT was created in 1969 as a "temporary fix" in order to soak the rich.  At the time, it only applied to the richest 116 rich households!  Due to inflation and other changes, it affects more and more Americans every year.  Each year, Congress has passed a one-year "patch" to limit the impact.  Not this time...)  The combined impact of these tax changes is that the average household will have about $2,000-$3,000 less in 2013.  Also, taxes are increasing on Capital Gains and Dividends, discouraging both business and personal investment.  Separate from the Fiscal Cliff issues, taxes will be increasing for other reasons, including ObamaCare which will greatly increase payroll taxes, making US employees and hiring more of a burden to companies of all sizes.  Also, estate taxes will increase.  The impact of all of this is:  People and companies will have less money in 2013 and less incentive to spend, invest and hire.  Economic activity will slow. 

The government spending cuts are probably more damaging and will directly and immediately increase unemployment while hurting American security.  If you believe that government stimulus spending really can boost an economy, these spending cuts will do the opposite.  These cuts will decrease GDP by 4% and will hit all areas of the federal budget - defense spending, payments to doctors in Medicare (30% decrease!), FEMA, education, etc...  Also, the often-extended Unemployment Benefits will end and the unemployed will have less money.  Many of these spending cuts will mean firing government employees, including teachers.  The impact of all of this:  Less government dollars will be spent in 2013 and the people who normally receive this money will have less money.  Economic activity will slow further. 

Arguably, the increased taxes and spending cuts do have a benefit - they will decrease the budget deficit (government spending minus government intake).

You might ask:  But, can't the President and Congress just find some compromise and fix all of this?  Answer:  No, not really...  The key point here is that the Fiscal Cliff is only a symptom of a much more important problem:  The National Debt (the amount of money which the government has borrowed and on which it pays interest).  The US spends more than it takes in every single day.  The US government owes $16 trillion dollars!  To put that in perspective, that's larger than the age of the universe -- the Big Bang took place 13 trillion years ago.  The government pays out $1.2B every day just on the interest against this debt.  Let that sink in...  That's money that can't be used interest for social program or defense or education or NASA.  This debt amounts to over $140,000 per taxpayer.  (This is on top of each person's personal debt....)  Over 40 cents of every dollar the government spends is borrowed. 

 

If the government doesn't solve the National Debt problem - by raising taxes and decreasing spending - the country will go bankrupt.  Avoiding the Fiscal Cliff is not enough...  If the government announces small fixes for only one or two of the symptoms, it will be loudly signaling that it's not serious about reducing the debt significantly and everyone will know that we're unable to control this problem.  Confidence in the US and the economy will crash.  The last time this happened, the US's credit rating was downgraded, making it more expensive for the US to borrow.  The people loaning the US money (aka China) will begin to worry about the US's ability to pay back - and some will stop loaning the US money.  (This is what's happening to Greece and Spain right now...  They can't borrow more because it's obvious that they can't pay back.  Riots in the street, national strikes and Molotov cocktails will be coming to a city near you.)

So, delaying a resolution to the debt problem will only make matters worse.  To have a long-term solution to the debt problem, the government will have to dramatically reform entitlements (Social Security, Medicare, ObamaCare) and the tax code.   To put it mildly, this is unlikely.  Further, it's hard.  It's Rubik's Cube hard:  You can't solve the National Debt -- by raising taxes and cutting spending -- without breaking the economy -- with higher taxes and pending cuts.  Our current politicians have shown no ability to crack this nut.  It will not happen before New Year's Day.

 

To fix the problem, we need a "Fiscal Ladder" - a real plan that really walks down the debt over a longer period of time.  No one in government is even talking about this.  They are simply working to slow the rate of increasing the debt.

 

So, what will happen if we go over the Fiscal Cliff?  Bankruptcies, firings, lower wages, higher unemployment and the value of "things" will decline (like stocks and bonds and commodities and house values).

 

Everything above is a fact.  Now some opinions and advice. 

Opinion:  I expect something equivalent to The Great Depression to occur.  Really.  It will be self-inflicted.  Voters are voting themselves more and more entitlements and expecting fewer and fewer taxpayers to pay for them.  The top 5% of earners pay 35% of all taxes while the bottom 50% pay 3%.  Politicians are promising more and more "free stuff" and less freedom.  The free stuff has to be taken from others via taxes or borrowed.  Hence, the large National Debt.  This can't last.  The math doesn't work.  It also encourages bad social behavior:  Success - even education - must be vilified by these politicians in order to justify taxing them at ever increasing rates.  The system is already unfair and untenable.    Meanwhile, voters are addicted to and dependent on free stuff (indefinite unemployment pay, social security, free phones, government loans, etc...) and have been taught that they don't have to work (aka add value to society) to earn a salary.  They just need to know which government line to stand in and "community organizers" help them with that.  Few politicians get re-elected by taking away free stuff or by raising taxes.  Politicians are willing to offer anything that other taxpayers can fund.

 

Bottom-line:  I don't see how the country avoids a major economic and social crisis.  States are already filing petitions to secede from the US...

 

Advice:  (I won't actually give any advice.  Everyone's situation is different and everyone needs to make up their own mind.  But I will tell you what I'm doing.) 

 

Summary:  I'm selling most - but not all - of my investments and moving my cash to the sidelines.   And, I'm actively shorting the market and the US with about 10%-20% of my investments.  I believe that other investors -- investors that are a lot smarter than me and have the ability to really move the market -- will be doing the same.  They already are. 

 

Here's what I'm doing:

1. In general, selling!  Prices will be going down and investments will be losing value.  Move to cash. 
2. Include IRAs, 401(k)s and Mutual Funds - no one call afford to lose money in these accounts.  Move to cash.
3. Sell any accounts with a capital gain - taxes on capital gains will go up next year.  Protect your gains!  Big investment firms are doing the same and will for the remainder of the year and this will drive down prices.
4. Sell "safe" dividend stocks - taxes on these will go up and they will be less attractive to investors in 2013.  The prices of dividend stocks will go down.
5. Build up investments that benefit when the market goes down or volatility increases.  There are many ways to do this but require more than a beginner's understanding of investments.

But Dave - you say -- what if you're wrong and the crash doesn't happen and the government averts the Fiscal Cliff, or at least tricks people into thinking it has averted it???  Won't you lose out?  My answer:  Maybe...  I won't make as much money but I will protect the money I have.  And, after the all-clear is signaled, I can always buy back my investments or new ones.  In fact, I expect to buy back in after stocks go lower -- much, much lower.  I'd rather not make money than lose money.

 

The purpose of this message was to explain what the Fiscal Cliff is and that it's really only a symptom of a much larger problem, the National Debt.  I've tried to explain just how important this is and how it will impact all of us.  I think the impacts of the National Debt and the Fiscal Cliff are unavoidable.  The actions the country can take are in the hands of our politicians.  They're the same people that caused all of this.  Be leery of any "quick fix."  The best case scenario is to slowly reduce the debt over many, many years.  You have to decide for yourself whether you think that's likely or whether a crisis must occur to force a true solution.