4 Questions to Understand the Fiscal Cliff

Judging by media coverage, the so-called "fiscal cliff" is the only thing driving the U.S. stock market these days. Unfortunately, a lot of the coverage is either alarmist, erroneous, or focused solely on the daily (or even hourly) micro-developments in the story. Here are four simple questions with answers I hope will help long-term investors frame the issues properly.

1. What is the fiscal cliff?
The "fiscal cliff" is, to use another metaphor, a perfect storm of tax increases and government spending reductions that are set to begin on Jan. 1, 2013. These changes stem from a number of sources, including:

  • The 2011 Budget Control Act, which put an end to last year's debt ceiling crisis. One of the provisions called for automatic across-the-board cuts in defense and discretionary spending if Congress failed to enact spending cuts voluntarily.
  • Expiration of the George W. Bush tax acts, which were extended once by President Barack Obama in 2010.
  • Expiration of the 2% Social Security payroll tax cut and federal unemployment benefits, both of which were extended by President Obama in 2012.

Without any countervailing action from lawmakers, the policy path we are now on would significantly reduce the budget deficit in 2013 -- but at great cost to the economy.


2. Why is it called a "cliff"?
The Congressional Budget Office estimates that if no action is taken to avoid the fiscal tightening from the combination of lower government spending and higher taxes, the U.S. economy will shrink by 0.5% next year on an inflation-adjusted basis. In many areas of ordinary life, a half-percent decline in some metric or quantity isn't terribly consequential; often, it will go completely unnoticed. If you have $2 in change in your pocket, you're unlikely to be concerned by the loss of a penny. A student who scores 100 on her first test won't panic if the next test comes back marked 99.5.

When it comes to the U.S. economy, however, the decline equates to recession and all the unpleasant things that go along with it. Let's get specific: According to the CBO, under that scenario, the unemployment rate would rise from its current level of 7.9% to 9.1% by the fourth quarter of next year. The last time the unemployment rate was at that level was in July 2011. The U.S. economy could effectively lose the benefit of nearly two and a half years' worth of improvement.

3. It's not really a cliff, though, is it?
Well, no. Federal Reserve Chairman Ben Bernanke coined the expression "fiscal cliff" in a Q&A session during his Semiannual Monetary Policy Report to Congress on Feb. 29, 2012. Bernanke chose it voluntarily to focus lawmakers on the risks associated with premature fiscal tightening, and it has become popular as shorthand for the damage that lawmakers' inaction could wreak on the economy. However, the metaphor is misleading in that it suggests an immediate, sharp, and irreversible drop-off in economic activity on Jan. 1. Think Wile E. Coyote running off the edge of a cliff and plunging into a canyon while chasing the Road Runner.

In reality, that's not what would happen here. For example, the CBO estimates I cited above assume that lawmakers do nothing whatsoever throughout 2013 to alter the current policy path. Instead of a coyote going off a cliff, think of a car without steering starting down a long slope toward a wall. The sooner the driver applies the brakes, the less damage the car takes when it car reaches the wall.

4. So if Congress and the White House act in time, we can avert any negative impact on the economy altogether?
Not so fast! There is plenty of anecdotal evidence that the fiscal cliff is already having an impact on companies' behavior, whether they be Dow Jones Industrial Average or S&P 500 components or smaller businesses across the country.

With the release of its Beige Book business survey last Wednesday, the Fed said that seven of its 12 districts reported "either slowing or outright contraction in manufacturing," with some respondents "[expressing] concern about the outlook for 2013, in part, due to the uncertainty regarding the outcome of the fiscal cliff."

Meanwhile, investment bank Goldman Sachs published what it calls its S&P 500 Beige Book at the beginning of November, according to which the fiscal cliff was one of the top three concerns cited by companies in their third-quarter earnings conference calls. Blue-chip names that referred specifically to fiscal-cliff-linked uncertainty as an impediment to planning include McDonald's , General Electric , and JPMorgan Chase .

It's possible that companies are only deferring spending and investment and will make up for any shortfall attributable to the fiscal cliff once the issue is resolved. However, it's a reasonable assumption that the longer the issue remains outstanding, the greater the probability that some of its impact will be near-permanent as companies raise the risk premium they attach to all policy-related uncertainty. That assumption looks even more plausible if we consider that any fix will likely only be a prelude to a broader, more complex negotiation to achieve a U.S. fiscal position that is sustainable over the long term.

The bottom line
The Motley Fool wants to help investors understand enough about the fiscal cliff to recognize how significant it is in the context of a long-term investment strategy. This article kicks off a series of four articles -- published daily for this week -- that will examine different aspects of the fiscal cliff. Be sure to visit Fool.com tomorrow for part two of our series, in which we'll take a closer look at the cliff's impact on individuals.

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The article 4 Questions to Understand the Fiscal Cliff originally appeared on Fool.com.

Alex Dumortier, CFA, has no positions in the stocks mentioned above; you can follow him @longrunreturns. The Motley Fool owns shares of General Electric Company, JPMorgan Chase & Co., and McDonald's. Motley Fool newsletter services recommend McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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