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The fiscal cliff may be overblown

November 9, 2012: 10:32 AM ET

The U.S. isn't headed off the fiscal cliff or any other make-believe economic chasms, at least not anytime soon. Congress set this time bomb in motion and it will disarm it before it explodes.

By Cyrus Sanati


Go ahead. Jump.

FORTUNE -- The markets have taken a beating since President Obama trounced Mitt Romney in Tuesday's election. The Dow is down 3% in the last two trading sessions and looks to be headed further south on Friday. While it is true that the markets historically take a dive after an incumbent president wins reelection, this latest drop has many on Wall Street on edge. Forget the weak corporate earnings, the freak hurricane that hit the East Coast and renewed troubles in Europe – no, this is all because of one thing: the looming fiscal cliff. Or that is what we are to believe.

Indeed, the fiscal cliff is about as real of a problem as the nation's burgeoning national debt – it's theoretically bad, but it isn't bad enough for Washington to risk making the short term any more economically unpleasant than it has to be. After all, there will be elections for the House in just two short years, so neither side wants to go into that election cycle trying to defend why the government instituted growth killing spending cuts while allowing taxes to shoot up to address some arbitrary debt load that investors continue to fund for next to nothing.

Thursday, the nonpartisan Congressional Budget Office released its latest short and long-term economic forecasts for the country. Given all the hubbub over the fiscal cliff, the government bean counters so kindly presented two contrasting views of the economy – one in which the government drives off the fiscal cliff, which it must under current law, and one in which the government turns and just continues to drive on the edge of fiscal irresponsibility.

If the government gets caught up in partisan gridlock, all the Bush era tax cuts end on January 2nd – including those on capital gains and dividends (hence why the equity markets are in such a tizzy this week). Since the Congressional "super committee" failed to lay out at least $1 trillion in spending cuts over ten years as required under the Budget Control Act passed last summer, there will automatically be $600 billion in cuts to discretionary and mandatory spending and another $600 billion in defense-related spending (this is called the "sequester"). Together, the increase in taxes and the decrease in spending is what make up the dreaded fiscal cliff.

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So how does the U.S. economy fare down the rabbit hole? In a nutshell, the CBO projects that it would produce some major short-term pain with relatively little long-term benefits. The increase in federal taxes and the reductions in federal spending would cut the budget deficit (the difference between how much revenue the government takes in how much it spends) from $1.1 trillion last year to $641 billion in fiscal 2013, roughly a $500 billion cut. That represents a reduction in the budget deficit (as a percentage share of GDP) not seen since 1969 when the conservative Richard Nixon booted the free-spending Lyndon Johnson out of the White House.

The cuts in spending and the increased taxes will cause thousands of people to lose their jobs pretty much overnight (millions of Americans owe their jobs directly or indirectly to federal government spending). This would push unemployment up across the country from 7.9% to 9.1%. As a result, the CBO projects that real GDP would drop by 0.5% in 2013 after growing by 2.1% in 2012. Real GDP would fall at an annual rate of 2.9% in the first half of next year, tipping the nation into a recession that the CBO figures would be similar in magnitude to the one the nation experienced following the first Persian Gulf War in the early 1990s (for those who didn't live through that, it was bad). The CBO anticipates that the Federal Reserve would engage in another round of quantitative easing and buy up bonds in the open markets to keep rates low – this would ironically be done by printing money out of thin air (but no one in Washington, save Rep. Ron Paul, seems to care about that). This counterweight to the spending cuts should help support the markets, but it probably won't be enough to counter the negative impact associated with the tax increases on dividends and capital gains.

That all sounds pretty grim, but the CBO suggests that the nation would begin to rapidly adjust to the fiscal cliff, projecting that economic growth would "be brisk" in 2014 and 2015, pushing economic output back to where it projects it will be if the government doesn't head down the fiscal cliff. Unemployment would remain elevated but would fall back to 8.4% in the last quarter of 2014 and then drift down slowly to a more reasonable 5.7% by the end of 2017.

For all the panic that the fiscal cliff has set off, it doesn't seem like the end of the world. But the short-term pain of having a double-dip recession could have a host of unintended consequences that aren't fully quantified in the CBO's projections.

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So what if nothing is done and Congress and the President just pretend that the Congressional Budget Act of 2011 never happened? They can do that by basically voting to extend implementation (indefinitely) or by just passing another law that would replace the Budget Act. Remember, it was Congress that handcuffed itself -- it still has the key to unlock the cuffs at any moment. If it does and nothing changes, then the CBO projects the economy would grow between 0.1% to 3.3% in 2013 – a wide margin, no doubt, but clearly a more desirable outcome than a 0.5% contraction associated with the fiscal cliff scenario. Unemployment would stall at around 8% through 2013 before eventually falling to around 7% by the end of 2014.

By not going off the cliff, the CBO estimates that deficits over the next decade would rise by a total of $7.7 trillion (that's "trillion" with a "T"). That would bring the total national debt somewhere to around $24 trillion by 2023 which is equal to 90% of GDP (that's pretty high). If we go off the cliff, don't expect a clean slate, though, as the nation would still have a significant budget deficit equal to 58% of GDP in 2023 due to all the mandatory spending associated with the impeding explosion in costs emanating from Social Security and Medicare.

This is where it becomes difficult to gauge the benefits of going over the cliff. Given that the nation would still be running a significant budget deficit, with a national debt that would probably still be around where it is today, is going over the fiscal cliff worth all the short-term pain?

The CBO believes that the higher deficit that the nation would have in 10 years if it did nothing would lead to less private investment, which would lower productive capital therefore reducing output and wages relative to where they would be by going over the cliff. It bases this on the belief that people's incentive to work and save by keeping more of their money would not outweigh an assumed decrease in national savings and investment that comes from having lower debt. The CBO tried to quantify the net benefits and costs and they found that after 10 years it still could go either way – spanning a range for real GDP from a decrease of 2% to an increase of 2.1%.

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This is the biggest problem with getting on the budget-cutting bandwagon – even in the long term it is unclear if sacrificing spending to check budget deficits really pays off. We know it won't in the short term, given the shock to the system, but even in the long term it's unclear. The CBO suggests that beyond 2022, rising budget deficits, accrued by not going over the cliff, would lead to larger negative impacts on GDP and cause interest rates to rise. But it estimates that the interest rates on 3-month Treasury bills and 10-year Treasury notes would just be 0.4 percentage points higher - 0.4%, really? That's all the nation gets for incurring a terrible couple of years – a lousy 0.4% reduction?

Projections are projections, and they are spectacularly wrong most of the time – especially when trying to forecast out 10 years. The message the CBO is sending makes sense – a higher debt to income ratio means that it will be harder to invest and harder to obtain credit. That's how it works in the "real world" (i.e. for you and me), but not for the US. Wall Street, Main Street and the world believe that the US, for some reason, gets a pass. S&P downgraded the credit rating of the US last year noting the nation's high debt ratio and its dysfunctional government was hurting its standing in the world. But the markets didn't care, pushing yields on US treasuries to their lowest point ever – short term bills were actually negative. This means that even though the US tacked on an extra $1.1 trillion to that national debt this year its debt payment went down because of the super low rates.

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But the market is fickle and can turn on you at any time. If for some reason a bond manager wakes up one morning and decides to short US debt, he or she could set off a huge sell off in Treasuries that could eventually send yields sky high in a matter of days. We saw that in Europe where Italy was paying yields around 2% one month and then close to 7% the next. The chance that the market moves against you increases as your debt to income ratio rises, but not necessarily.

It is therefore hard for politicians to so brazenly throw the nation into a deep recession to reduce spending when the benefits of acting are so intangible. The fact is that the Budget Control Act of 2011 was political theater in which the Republicans tried to appease "Tea Party" voters – a constituency that has basically been wiped out as the economy has improved. Discussions around raising the marginal tax rate on the top 2% are simply just political fodder. Indeed, multiple studies, including ones by the CBO say that it would raise an insignificant amount of money (a negative for the Democratic view) but would also cause no real harm to the economy (a negative for the Republican view). In the end, if it takes changing the top 2% rate from 35% to 39.6% to end this whole fiscal cliff charade, you can bet it has already been agreed to.

As cynical as it may sound, it is simply irrational for either side to address the deficit in any meaningful way given how cheaply it is for Washington to borrow money. As we have seen in Europe, nations won't swallow the bitter pill of austerity unless the markets force them to. So while the equity markets are jittery about the fiscal cliff that is not enough for Congress or the President to present any real long-term compromise if the yields on Treasuries remain at near all-time lows. It will only be when it becomes too expensive to borrow that you will see the government act in any meaningful way to address the nation's long term fiscal issues, not a second before.

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