Why You Should Not Worry About the Fiscal Cliff

I’m not wasting my time worrying about the “fiscal cliff” and I suggest that you not waste your time either. Before I explain why, let’s review what the fiscal cliff is and where it came from.

A little over a year ago the US Government was about to run out of money again. That’s because the Federal Government has been spending more than it takes in for quite some time. As a result, it borrows. But it is authorized to borrow money only up to a certain point. That point is called the “debt ceiling”.

Well we hit that ceiling again in 2011 and legally we were unable to borrow more – unless we raised the debt ceiling again. Some of our political leaders thought that we needed more money to keep our economy from falling back into a recession. They wanted to borrow more so they supported an increase on that ceiling. Other elected leaders were against raising the debt ceiling. They were focused on getting the government to spend less.

Are you facing your own fiscal cliff? If so, the best thing you can do is cut your spending and increase your income. Duh. That’s obvious. But what isn’t so obvious is how easy it is to cut your cost of borrowing if you have high cost debt.

In the end, they agreed to raise the debt ceiling on the condition that a long-term solution be found. They further agreed that should they not find a solution by January 1st 2013, taxes would automatically go up and spending would automatically be cut. They did this in order to force the government to live within its means. And this tax increase and spending cut combo is known as the “fiscal cliff’.

What’s the problem with revenue increases (higher taxes) and spending cuts?

If you or I were facing a personal “fiscal cliff” that’s exactly what we’d have to do. But the government has other considerations – or so it seems. The economy seems to be on a (slow) recovery track right now and that’s a good thing. Tax increases and spending cuts would take money out of the system and possibly derail that recovery. As a result, more people might lose their jobs. That would hurt employees, employers and investors alike. At least that’s what many economists argue.

With so much at stake, why isn’t this something to worry about?

There are three reasons why I suggest you stay mellow:

1. Congress will probably find a solution.

Clearly there is a great deal at stake and most of our elected officials want to find a compromise. It may take a few more weeks but it’s likely that they will find a way to work together now that time has run out. In fact, the longer it takes the more likely it is that a better solution will be found. That’s because as pressure builds both sides will become more amenable to negotiation.

Everybody knows that the real problem we face is government spending. But any politician who supports spending cuts risks losing votes. As the gravity of the situation increases it will be easier for elected officials to do what they already know they have to do but are afraid of doing.

Even if taxes go up and spending is cut, the economic impact will be slight. Take a look at the proposed cuts to military spending. Out of an annual budget of $611 billion, the sequester will shave $48 billion – or 8% on an annual basis*. But that’s less than 1% per month. So if it takes the government 6 weeks to work this problem out, a grand total of 1% of planned military spending will have been taken off the table. That’s not enough to move our economy one way or the other.

The same logic applies to other program cuts and tax increases. The broad cuts and revenue increases might be a real threat to the recovery if they stay in place. But the odds are high that even if these measures are executed, they won’t stay on the books for very long at all.

2. Congress may not find a solution. Is that so bad?

Until Congress finds a way to play nice, these tax increases and spending cuts will remain in effect. That’s true. And these measures could be painful and could even push us back in to recession. But some experts argue that the momentum of our housing and employment recovery would counter the slowing impact of the fiscal cliff.

Nobody really knows what the result would be. And some people feel that it might be the only way to get government to stop spending money it doesn’t have. This “fiscal cliff” might be the medicine we need to take even though we know it doesn’t taste very good. We’ll see.

3. The Stock Market

Recent market performance has been pretty good. Not perfect, but pretty good. The market could be telling us that one way or the other the “cliff” we’re so afraid of is just a little “mound”. And if the stock market does a tail spin because of the cliff thing, couldn’t it take off like a jet once this impasse is solved? I’m not certain that anyone really knows.

From an investment stand point I believe it’s a waste of time (and potentially very expensive) to change your investments or investment strategy based on the fiscal cliff. I believe you are far better served by watching the market and allowing it to guide your investment decisions instead.

How do you feel? Are your changing your investment strategy based on the fiscal cliff? Are you going to make any huge changes to your portfolio if a deal isn’t struck very soon?

*http://en.wikipedia.org/wiki/Military_budget_of_the_United_States

*http://www.foxnews.com/politics/2012/12/28/pentagon-defense-industry-brace-for-looming-spending-cuts/