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What is the Fiscal Cliff?

By , Money Morning •

What is the fiscal cliff, and how do we avoid it?

The fiscal cliff will be crossed on Jan. 2, 2013 when $530 billion in tax increases and spending cuts at the federal level take place due to a previous budget agreement between Congress and the Obama administration.

Since Congress and the Obama administration could not reach an accord to reduce the federal budget deficit, a series of automatic tax hikes and decreases in spending will take place instead to achieve the necessary savings.

This is much like the Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act from 1985. The fiscal cliff will pack a one-two punch to U.S. cities that are already burdened by heavy debt loads, and raise taxes on U.S. households struggling to recover.

What is the Fiscal Cliff Effect on the U.S. Economy?

According to the Congressional Budget Office, a non-partisan organization, if there is no other agreement and the fiscal cliff is crossed on Jan. 2, the United States could fall back into a recession in 2013.

That will have a tremendous negative impact on the global economy as Europe is in a recession and economic growth is slowing in China and India.

Based on the 320-point drop in the Dow Jones Industrial Average the day after President Obama's re-election, Wall Street is not bullish about the future of the economy.

Reinforcing this negative outlook, Fitch Ratings stated there would be no "fiscal honeymoon" for the Obama administration. Along with hitting the fiscal cliff, the U.S. government will reach the debt ceiling of $16.4 trillion.

In a statement, Fitch Ratings warned that, "The economic policy challenge facing the president is to put in place a credible deficit-reduction plan necessary to underpin economic recovery and confidence in the full faith and credit of the U.S."

Standard & Poor's, another of the major rating services, downgraded the credit grade of the United States in August 2011 from AAA to AA+.

And that could be repeated in 2013.

Fitch further advised that, "Avoiding the fiscal cliff and a timely increase in the debt ceiling would support the economic recovery and send a positive signal that agreement can be reached on a credible plan to reduce the federal budget deficit and stabilize federal debt over the medium term, consistent with the U.S. retaining its 'AAA' status. Conversely, failure to reach even a temporary arrangement to prevent the full range of tax increases and spending cuts implied by the fiscal cliff and a repeat of the August 2011 debt ceiling episode would mean that the general election had not resolved the political gridlock in Washington and likely result in a sovereign rating downgrade by Fitch."

What is the Likely Outcome of the Fiscal Cliff?

It is likely that a temporary measure will be passed to avert the fiscal cliff.

While that is unlikely to please Fitch, Moody's and Standard & Poor's or Wall Street, it will protect the United States from the ill effects of the fiscal cliff that could result in the country plunging back into a recession.

While it does not receive much attention due to the approaching fiscal cliff, the United States has been operating without a budget resolution for years now. There has been a breakdown in the budget process in Washington, DC. Although the appropriations process is purely the purview of Congress, there still has to be agreement with the executive branch to pass a budget for the U.S. government. That has not transpired due to the existing poor relationship between the House of Representatives being controlled by the Republicans and the Senate being controlled by the Democrats.

Unless a budget deal is reached by the Republicans and Democrats before Jan. 2, 2013, the fiscal cliff will be come into effect with its spending reductions and tax increases. From that, the suffering will be felt across party lines and around the world.

For more analysis on what is the fiscal cliff and how it will affect you and your money, check out our special report section here.

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