What is the “Fiscal Cliff”? Should You Care?

by Neal Frankle, CFP ®

No doubt you’ve heard about the looming financial meltdown that we face January 1st 2013. But what exactly is the fiscal cliff and what does it mean to you? Let’s discover together.

What is the “fiscal cliff”?

This is a term that has been ascribed to tax increases and government spending curbs that are to go into effect at the start of 2013.

Come January 1st, there will be huge tax hikes (on some taxpayers) and spending cuts by the Federal government if Congress doesn’t agree on a plan to cut the deficit another way. The result of these changes would be an immediate contraction in our economy. Some say it would suck money out of our system faster than you can say “recession”.

How did we get here?

The fiscal cliff was a compromise deal worked out about a year and a half ago. Congress was (and still is) gridlocked over the battle between spending cuts and tax increases. The automatic increase in taxes and spending cuts (the fiscal cliff) are the “compromise” our boys and girls in DC worked out in order to increase the debt ceiling at the time and kick the can down the road.

What are the potential downsides to the “fiscal cliff”?

On the one hand, when the government spends less money it reduces demand for goods and services. As a result, the people who supply those goods and services cut back on hiring and investing.

And when taxes go up, individuals have less money to spend. That means they also cut back and demand drops. As a result, businesses tighten their belts and lay off workers.

So the bottom line is that if there is no agreement, it’s going to hurt or economy big time.

How much damage could it cause?

The IMF estimates* that the price tag for this will be about $700 billion – or about 4.5% of the GDP.

Here’s why that’s a problem. Our economy is growing at less than 2%. So if the economy contracts that much, we’ll be in a recession because we’ll be experiencing negative growth.

Are we doomed? Is it all over?

I don’t think so. Falling off the fiscal cliff would be a bad thing initially. There is no doubt about it. But there is disagreement as to the real long-term effects of this. The Congressional Budget Office says that even if we take the tumble, the economy would rebound in the second quarter of 2013.

I could be wrong but I really don’t expect the “fiscal cliff” to go into effect. As I write this, Congress is actually working together (novel idea) on closing tax loopholes for the wealthiest tax payers as a place to start building common ground. Whether or not you agree with this policy, you have to appreciate the fact that (maybe) our Congress people are learning to play nice with each other. The odds are that Congress won’t throw our economy into the abyss. And who knows, if our government learns to work together on this issue, maybe they’ll be able to address other problems as well.

Time will tell. I don’t have a crystal ball so I can’t predict what is going to happen. It’s likely that we won’t fall off the “fiscal cliff”. I think that Congress will find a stop-gap measure, put a band aid on the problem and kick the can down the road one more time. Of course that doesn’t address the systemic problems of entitlement spending and a super-complicated tax system.

That’s going to require lots of compromise, hard work and time. But I believe there is a chance that these problems will finally be taken seriously by the government. Here’s hoping.

Should you change your investment strategy now?

Ever since the election, the market has shifted its focus to this financial issue. The results have been bad. (By the way, I personally do not believe that this is a result of President Obama’s re-election. The fiscal cliff was a problem that would have to be reckoned with regardless of who won.)

Many people feel that the current market downturn is an emotional response that could easily turn around quickly. Nobody knows right now. Either way, you are better served by finding the right investment strategy and sticking with it rather than reacting to this (or any other) news. If you have a “market sensitive” strategy, follow it and let the system tell you what to do. If you are a buy and hold investor, you know what to do.

Are you concerned about the fiscal cliff? Are you changing any of your investments as a result? Why or why not?

 

http://finance.yahoo.com/news/imf-urges-permanent-fix-u-015216962.html

email

Subscribe & Get Your Free E-Book and E-Course as My Gift to You!

Investing Your Money Made SimpleOnce a week you'll get unique tips to make smarter money decisions about your investments, retirement, taxes, and career. You'll also get encouragement and ideas to help you get out of debt, earn more money, and generally stop worrying about your money.

Neal Frankle is a Certified Financial Planner™ with over 25 years experience. Subscribe today and tap into this wonderful, free resource!

Become a Fan! Follow @NealFrankle

{ 4 comments… read them below or add one }

Rich Leivenberg December 24, 2012 at 7:06 AM

Neal – Thanks for talking about the fiscal cliff, a terribly hyperbolic term that has us all scared. I mean, who wants to fall off of a cliff? I think the effects of the cliff have already been felt. I, for one, am taking a wait and see approach before investing any more into the market. I feel good about my current investments as being more conservative than speculative.
But, I am not as confident as you are about the government’s ability or desire to compromise enough to actually make a deal that prevents the cliff. As one financial pundit said, “it would be nice to parachute rather than just fall off the cliff like Wile E. Coyote.”
One of my fears is that the results of a non-deal may be too swift for us to react to and that the market will drop off dramatically resulting in panic and a huge sell-off.
Do you think that is possible? Or do you think the effects, if negative, will be slow?
I have to say that I thought things were looking up for the economy and am disappointed and worried by our government’s ineffectual policies.
They need to compromise!

Reply

Neal Frankle December 26, 2012 at 7:59 AM

I agree Rich. Both sides need to compromise. But we’ll see what happens in a few days. The market seems to signal that we are not facing dire straits. Let’s see what happens…..

Reply

Julien November 21, 2012 at 10:02 AM

thanks for this insight, i’ve been wondering how the fiscal cliff would affect people

Reply

Neal Frankle November 21, 2012 at 10:20 PM

Glad it was helpful!

Reply

Leave a Comment


5 − = two

Previous post:

Next post: