The Cold Hard Truth About the Fiscal Cliff Deal

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In the end, a last-minute deal emerged. Just like that, the fiscal cliff crisis was averted.

In the waning hours of New Year's Day, Congress voted to avoid a large package of tax increases, along with some modest spending cuts.

Not surprisingly, the markets just loved it. The Dow soared over 200 points on the open and never looked back.   

But first, let's call this deal what it is: a late-day compromise that failed to address serious fiscal issues.

In the end, the agreement reached on Tuesday night will only reduce the deficit by about $60 billion annually over the next 10 years. 

That's less than 10% of the total projected deficits, which means well before 2020 we will likely have a real crisis on our hands.

But the real story in this mess is this: the cold hard truth is that going over the cliff would have actually been beneficial.  And despite the promises of Keynesian economists, the deal that emerged was not an improvement.

In reality, the predictions of doom that surrounded the fiscal cliff were made to achieve a political goal, and we should have ignored them.

Here's why…

Why We Should've Jumped Off the Fiscal Cliff

First, let's deal with the unpleasantness up-front. Paying higher taxes is a pain, and the fiscal cliff would have raised taxes on everybody, not just on the "rich" with incomes of $250,000 a year. In the new deal, the break is at $400,000 for individuals and $450,000 for couples.

Of course, in an ideal situation, the government would have cut spending from its current bloated levels, returning spending to its long-term average as a percentage of GDP.

But let's face it; that would be very difficult.

New legislation such as the 2001 "No child left behind act," the 2004 Medicare prescription drug entitlement, and Obamacare, as well as the wars in Iraq and Afghanistan, have permanently increased the size of government, while relaxed regulations have allowed 47 million people to draw food stamps, worsening the problem. 

In any case, since we don't have an ideal government – as the fiscal cliff crisis proved yet again — anything more than minor spending cuts are almost impossible to obtain.

The reality is that falling off the "fiscal cliff" had two advantages.

First, it solved 77% of the next 10 years' budget deficit problem. The 10-year budget deficit would have been reduced from $10 trillion to $2.3 trillion, according to Congressional Budget Office figures, or annually from an average of $1 trillion to $230 billion.

The other big advantage of the fiscal cliff was that it increased middle-class taxes, something almost impossible for politicians to do directly.  That's important.

You see, for years voters have been getting $1 trillion more in government services than they have paid for, with Ben Bernanke financing the difference at rates below the inflation rate (hence negative in real terms.)

Naturally, voters like this and vote for more free largesse.  But this needs to be stopped; the country simply cannot afford to run continual $1 trillion deficits, imposing huge liabilities on our grandchildren, and the deficits cannot be closed by increasing taxes only on the rich.

Using middle-class taxes to force voters to pay for the bloated government they support in the polling booth is essential to the health of American democracy.

In reality, spending must be paid for on a current basis, so that the electorate can realize its cost. The fiscal cliff achieved this; the compromise deal doesn't.

More Trillion Dollar Deficits

Now, with Bernanke still in charge, the deficits will continue at close to $1 trillion per annum until the bond markets refuse to accept Treasuries. You can't imagine the recession THAT would cause.  The U.S. would become Greece on a gigantic scale.

However, it's beginning to appear inevitable, though probably not in 2013.

What's more, the fiscal cliff would have only caused a minor slowing in the economy, because the reallocation of resources would have been so sudden.

However, after the first few months, the $700 billion reduction in the budget deficit would have caused long-term interest rates to fall even further, with 10-year Treasuries yielding below 1%.  Plus, the additional $700 billion in taxes paid and spending curtailed would have been matched by an extra $700 billion available in capital markets for non-government uses.

Instead, with the compromise deal, bond yields will rise, as the deficits become obviously more dangerous, and the lack of progress against them becomes more apparent.

However, the good news is the equities and commodities markets should enjoy a bounce in the short term, as Ben Bernanke buys enough Treasury and Agency bonds to offset the deficit. With the European Central Bank also buying bonds to support the dodgier economies of southern Europe, and the new Shinzo Abe government in Japan prodding the Bank of Japan to redouble its bond-buying efforts, liquidity in the markets will expand further.

For investors, the message is clear. Avoid Treasury bonds, maybe even go short. Keep a position in stocks, especially in Canada, Australia and emerging markets where policies are not so foolish as in the U.S., Europe and Japan. And buy precious metals.

Here's the bottom line: The messy compromise doesn't solve anything.

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Join the conversation. Click here to jump to comments…

  1. John Brown | January 3, 2013

    Thanks for the advice, which I am sure is good for investors. I have to give a local spin to it, from my position in the UK.
    But with the USA poised to achieve energy independence, and probably export a lot of LPG too, in about 5 years, won't that cause the deficit to reduce at 10% per annum, or even more?
    So low reductions by other means in the short term, might pale into insignificance in the longer term. In the meantime, the continuing fiscal measures should enable you to rebuild your manufacturing industry.

  2. Clayton Bagwell | January 3, 2013

    Stupid Congress. Continuing to support hungry people with food stamps!! and TAXING people who are making over $400,000 a year! How unfair. Doesn't Congress know that the rich have become ACCUSTOMED to having their debts picked up by the poor folks eating from food stamps? What do they call it…QE? Come on, let's go to war, maybe this time with Syria. That Libyan deal was too short. We can still cut medical care and assistance to the elderly so that our young people can play video games with investment papers. They can brag, "HaHa! I traded faster than you did!" What a sick country, run by a bunch lunatics with bought and paid for Executive, Judiciary and Legislative branches. What more can the rulers ask for; they already control everything and yet they cannot avert the recurrent disasters. My Gawd!!! Was Marx right? Is there a spectre haunting capitalism? Is this the best of private enterprise/property worlds? Is no medicine, no education, no food and more war the best that capitalism can do? Apparently so!!

    • zig | January 3, 2013

      You are an idiot, Food Stamps, most of those receiving pay nothing to there provider and if they do they shouldn't be receiving them! You libs just don't get it, The US Government does not have a revenue problem, they have a spending problem!

    • michael | January 3, 2013

      Poor peoplee?
      That's thee problem america's definition of "poor" is skewed.

      I see way to many people that aren't "poor" on food stamps.

      Loading their brand new infinitti suv with groceries paid for by a foodstamp card and driving to their new house. Cute

    • Scott | January 3, 2013

      I Think you are right on. Keep on writing and maybe somebody will pick up on what you are saying. But people are pretty ignorant out here

    • Robert in Canada | January 6, 2013

      Clayton has the same un-informed, mis-informed, convoluted, fantasyland way of thinking as a Greek union leader.

      Look what that did to Greece.

  3. Michael D. Suermann | January 3, 2013

    Where does Ben Bernanke, the Federal Reserve and other Central Banks get the money (or credit) to buy government treasuries? How much 'money' do they have at their disposal – perhaps they can buy enough government debt to keep the governments of the world operating for ever and then forgive the debt.

  4. Patrick | January 3, 2013

    Nothing new. It's the old Washington 2 step. Make it look like the politicians did something , when they didn't solve anything.

  5. Don W. Pendley | January 3, 2013

    To all;
    I am SICK of writers writing that "we CAN"T continue" to follow the financial path we are on.
    We CAN & WILL as long as we continue to elect 'criminals' to office who's only concern is being
    reelected and keeping their "cushy" jobs, and will sacrifice the American people to insure their
    individual continued prosperity – NOT OURS.
    IFF we (the American people) do not take back our republic from these "sleasy weasels", we deserve
    everything we get, and without serious changes, IT IS COMING!
    Stay sober.

  6. Jose Pinell | January 3, 2013

    Good morning!

    Why would you recommend to invest in other countries different to US when what we need is that investors put their money to work in the US economy creating jobs and helping raise more taxes?

    Regards,

  7. Werner | January 3, 2013

    Thank you, Martin, for this analysis. Not much joy in reading it, but lets face the facts, the US politicians have – IMHO – definitively squandered the little credibility they were left with. Financial markets are becoming political and that is a very bad omen. How long will it take for the rest of the world to realise that it cant rely any longer on US spending sprees and has to get on its own feet to survive. Looking at the rumours of Chines gold stockpile building that day should not be too far out. Beware, it will be a bloody mess for everyone and a terribly hard landing!

  8. Paul Livingston | January 3, 2013

    Start talking about a solution, help to educate the people…please.

    Let’s talk about real/true tax reform…moving the tax base from income, dividends, capital gains, investments, inheritance and savings to a tax base on consumption with one progressive sales/consumption tax system.

    Real/true tax reform to regain our lost financial freedoms by eliminating the IRS; reverse the outward flow of jobs, businesses and capital; create more jobs with tax code change; remove some $.22 per dollar of hidden taxes from higher prices we now pay; eliminate regressive payroll taxes; fight poverty; tax the underground economy and greatly reduce the taxing power of lobbyists, politician and others that use the tax code to their advantage.

    Learn more at http://www.fairtax.org

    Paul Livingston

  9. Curtis Edmark | January 3, 2013

    I agree. The solution becomes a bigger problem than the problem itself. In the late 19th century heroin was introduced as a "safe, non-addictive" substitute for morphine. Heroin was the solution to the problem of morphine addiction. How did that one turn out? The country handles its fiscal problems in the same way as this article confirms. Wonder how this one is going to turn out???

  10. mike | January 3, 2013

    "Using middle-class taxes to force voters to pay for the bloated government they support in the polling booth is essential to the health of American democracy." I don't agree. I didn't vote for govt programs that give money away to give to those unemployed or in need of food stamps. In fact, the govt enacts lots of spending programs that we do not vote on. I don't want to pay any taxes, let alone more taxes. Instead of increasing taxes, get rid of all the spending. The govt should be involved in very little, Possibly defense of the country, but nothing else.

    • Dave | January 3, 2013

      While you are voting to spend my taxes on the bloated military budget (over 1 trillion dollars once you count the hidden line items), I will vote to cover the entire food stamp program for less than the yearly cost of the nuclear weapons program plus a few tanks and fighter jets. As for unemployment spending, you might want to check and see where that money comes from.

  11. Lanell | January 3, 2013

    When the American people wake up and realize that poverty, health care, and retirement are NOT functions of government, perhaps we will be able to turn this country around. Our government should be concerned with defense, commerce, and infrastructure. Honest people working to pay massive taxes so others can continue to enjoy their addictions (drugs, booze, and laziness) is going to have to stop but expect no changes until it does.

  12. deane gilmour | January 3, 2013

    The real "cold hard truth" of the debacle bill to avoid the "fiscal cliff" is the unilateral compromise by the Speaker of The House and the majority of the other so called Republicans in the House to appease the "Ruler" of the free world and those ignoramouses that back him when not voting with their ipods for the latest American Idol contestants, or making sure they know the latest scores of the Gangsta pro athletes in order to have something to talk about around the water cooler.

  13. deane gilmour | January 3, 2013

    Barry's taxing the rich is a falsehood, as is the majority of that which proceeds from his mouth. The truely rich, such as the Kennedy's, Rockafellers, Mellons, Buffett, etc etc ( and Unions and such organizations as the NFL and NBA) will not be affected by the so called tax on the wealthy as they receive their daily spending monies from investments that are not included in that income to be taxed. Only those who work for "The Man" who make over $400k in a paycheck with withholdings, not dividends from investments on which taxes are paid not up front but after the fact and the accountant has figured their deductions that forego paying much tax if any at all. then of course there are the legal cheats who pay nothing or underpay to the tune of billions uncollected every year by IRS, many of whom are the very legislators who wrote and passed this debacle, this stop gap that will unravel shortly after Barry has "retired" with his guaranteed income and expense account for life. The truth is that the major corporations, so loudly touted the problem by the left, are the very backers of Barry and his anti-American cohorts.

  14. leocorionSociety | January 3, 2013

    JP Morgan has naked silver shorts positions that exceed available silver and the SEC refuses to prosecute, creating a green light for others to naked short the market with no threat of SEC action.

  15. Jeff Carlson | January 4, 2013

    Well our leaders could of lead us safely over the cliff with ropes and climbing gear and a little working togather. But they are going to wait until the bond market figures how bad off this country
    really is.And the whole world will throw us off the cliff, and at that point most of the rest of the world will go over with us. How long did the last depression last.

  16. Doug Hirst | January 4, 2013

    Barack Hussein Obama has done more damage to America than the combined forces of Germany and Japan did in the entire Second World War.

    • DD | January 4, 2013

      Doug – Oh please! Not that I support Obama, but I strongly suggest you read a book called The Creature from Jekyll Island by G. Edward Griffin. Here YOU will see how Republicans have also played a HUGE part in what's going on financially and militarily.

      It’s about time Rep’s realize there is almost no difference between them and the Dem’s

  17. C. Frederiksen | January 4, 2013

    Raise taxes to pay for the wars; what a concept. The U.S. did it in the late 40's and 50's and it seemed to work. We shouldn't forget who put two wars on the credit card and bribed the electorate with a promised tax rebate during the 2000 presidential election. (Clue — he is a Republican… or has he been kicked out of the Party?)

  18. Melanie | January 4, 2013

    This problem of taxes is because of the Military cost being way to high and causing the national debt to exist and significantly increase and the other
    major problem is the interest rate on the national debt. If there is one way to cut the debt would be to do major spending cuts to the military to almost nothing and to eliminate interest rates and to pay just the Capital and have the interest rate not to exist. I am Canadian and we pay higher taxes than U.S. citizens. I personally pay 35 % or more in personal income tax Annualy and most of Canadians income taxes is to pay for our nations debt which is caused by the military cost being too high and the interest rate. In fact, most of the income tax from Canadians is to pay for just the interest of debt and not the debt itself. Personally, I don't want to pay for a Canadian military nor interest of Canada's debt and I know that a whole lot of Canadians agree and that is why we have major spending cuts to the military and Canadians get upset when we spend more money on the military when we do not have the money to do so. Instead of fighting a war that cost lives. I think that the U.S. Government as the most well known Captialist country in the world should be the one that leads the war against interest rates and make it an illegal form of lending as a kind of theft. Instead of interest rates
    It would be one time low borrowing fee that would be paid at the same time as the capital debt. I also think that the U.S. Citizens like Canada should pay higher income tax to pay off their nations debt. Their are countries who do not have a military and some countries do not even have a debt.

  19. Ron from Dallas | January 4, 2013

    What should have been talked about as a solution:
    1. Reform the tax code: eliminate taxes on income, investments, capital gains, and savings; eliminate loopholes; tax comsumption, *possibly* trade, property *as a defense tax*, etc.

    2.Cut future deficit spending by prescribed 77% or more: aim first at the costs of our oversea expenditures. Look at the cost of foriegn aid and military occupation and also government support of NGO's. If our foreign policy costs anywhere near $1 trillion then that's the FIRST PLACE we should start slashingcut. Cutting food for the poor can wait, let's see if an rebuilt economy can feed them naturally. I'm sure the government can go without a few more drones.

    3.Audit and Nationalize the Federal Reserve Bank of the United States*kick out special interests, make them play by market rules*. Liquidate*repay to credit holder i.e. America* massive reserve debt built up by the "too big to fail" banks and break them up. Reset the rules of the financial game because theirs been a flag!! They need to be put in the penalty box..

    • Attila | January 7, 2013

      Cutting food for the poor should be the first priority. It is time we meet head on this dishonest pandering by the left, whose true purpose is to buy votes. The typical poor has TV, DVD, cell phones (even before they were free), air conditioning, a car, and more living space than any European (other than Luxembourg). Most countries in the world get less to eat than the poorest person in this country, excepting those with mental problems.
      Get an education; go down to your SS office and see who is applying for assistance. You are unlikely to see anyone who looks like they are deprived, but you will see a lot of very obese people.
      The Russian people have a saying, "No one becomes great without first great suffering." So what do we want, a nation of greats, or a nation of leeches?

  20. Gordon Garvie | January 4, 2013

    Silver bullion,not paper should be over a $1000.00 an ounce,WHY ISNT"IT. 572,000,000 ounces last year at $33.00 What a joke! 14% behind gold,what a joke! $1,000 plus an ounce would reduce a massive part of the Debt and keep it rising.So Called Precious metal my foot. All Banks World Wide should have to have a Silver Reserve and when the loaning limit is spent,no more Bucks.
    Come on Mr.Rothschild J.P. Morgan,you own the world,set the standard and instrument a REAL Price on Silver.
    Silver needs a real work over.Even the poor will benefit as they can sell their Necklace.

  21. Gordon Garvie | January 4, 2013

    Since there is only 1 Billion ounces of Silver above ground,65 Trillion Dollars since we started minting money,615+ Trillion of forward Derivatives now held by 4 Banks,was 80 banks would take 10 years to pay with no interest.Are we all mad and talk of a few bucks to the economy.
    Place silver 8-10,000 an ounce and then we have a few bucks for the economy.

  22. shipp@bellsouth.net | January 5, 2013

    Please show me where there was a deal anywhere. The Senate bill died because the President didn't sign it. So where is the deal? The bill passed in the house on January First that was sent from the Senate and Voted on with out being read was bill H.R.8 Are you referring to some other deal? ? Please explain. If the Senate bill had been passed, would that NOT have been too late. The year changes at midnight, or doesn't that count since congress was still in session from the night before? ? We are now in the 113th Congress. Was some thing else passed that I missed? ?

  23. Attila | January 7, 2013

    True, but too complicated. Call this what it is: corruption. It is the bane of any representative government, which has almost irresistible incentives to corrupt. The Founding Fathers sought to prevent this with a very limited federal government that was constitutionally limited to specified defense, diplomacy, and regulation of duties between states (original intent of the Commerce Clause) and a few other minor things. This means 80% of the current federal government operates illegally and quite outside its authority. All other powers were reserved to the states and to the people. Only when the people rise up and demand a return to legal government will it happen. One can only hope it will be a peaceful process, but be prepared if it is not.

  24. Google | January 29, 2013

    Nice article!

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