While the elections may be spooking the US dollar as well as the domestic stock markets, the real issue is how the politicians deal with the fiscal cliff after election day is over, warns John Mauldin of Thoughts From the Frontline.

In the third quarter of 2011, the US Congress agreed to rather severe tax increases and spending cuts that would kick in as of January 2013, as a way to get a deal done to increase the debt ceiling. In addition, the Social Security payroll tax cut and extended unemployment benefits are also scheduled to go away in January.

All told, if nothing changes, this abrupt shift in fiscal policy would result in a hit to the economy of about $650 billion, or a little more than 4% of GDP—at a time when the economy is likely growing less than 2% a year.

Let me break down the major components of the Fiscal Cliff:

  1. Abolition of the Bush tax cuts, which amount to $265 billion, of which $55 billion is for the “wealthy” and $210 billion for the “middle class” (everyone else). Almost no one on either side of the aisle wants to actually go forward with axing the tax cuts for the middle class. Republicans want to hold on to the top-level tax cuts, and to my mind that’s a bargaining chip (see below).
  1. The Budget Control Act, or the debt-ceiling deal, comes in at roughly $160 billion, with $110 billion of that in sequestration, mostly for defense. There seems to be a growing consensus that not all of these cuts should be made.
  1. The 2009 stimulus will also roll off (this is the 2% Social Security break and extended unemployment benefits). This amounts to $140 billion all on its own, or almost 1% of GDP. Almost everyone agrees that these tax cuts were supposed to be temporary.
  1. The “ObamaCare” $24 billion tax increase on high-income households is almost sure to be allowed to go through.
  1. Technically, there is $105 billion in the temporary “doc fix” and Alternative Minimum Tax, which every year are supposed to expire and every year are postponed, which of course allows Congress and the president (whoever is in control) to project lower deficits in the future, even though those cuts never happen.

If you add the $105 billion of fixes in No. 5 and the middle class tax cuts, you get $315 billion, or almost half of the Fiscal Cliff, which reduces the impact to 2% of GDP. Take some of the sting out of defense and you get to less than 0.5%.

But this creates a big but...what is your fiscal multiplier? It is not so simple as looking at what the IMF manufactures as a number and then extrapolating.

Without trying to be cute, the US is not Greece or Spain or Germany. We are perfectly capable of creating our own unique brand of chaos. It is all debt-related to be sure, but the similarities begin to break down when you look at the gory details.

Not all tax increases or tax cuts have the same multiplier, just as not all spending increases or spending cuts do. There is a big difference, as Gavyn Davies pointed out, between a fiscal multiplier of 0.5 and one of 1.7. Before we get into what our multiplier might be, let’s review a few facts.

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If Something Can’t Happen...
There is a rule in economics: If something can’t happen, it won’t. That may seem a tad obvious, but so many people are prone to think that the current trend can go on forever. This time is different, we tell ourselves.

Meanwhile, I and many others—David Walker, David Stockman, Alan Simpson, David Bowles, et al—are telling you that so much of what we’re doing is unsustainable that big changes in present trends, as much as we might not like to think about them, are inevitable.

So what we must think about now is what will happen when major change is either forced on a country or else entered into willingly. Sometimes you have to think the unthinkable.

Look at the projected debt for the US, compiled by the Heritage Foundation, based on realistic assumptions—not compiled while wearing rose-colored glasses. This is a chart of something that will not happen. Long before we get ten years of multi-trillion-dollar debt, the bond market will begin to demand much higher rates than we currently experience, driving up our interest-rate cost as a percentage of tax revenues to very painful levels, forcing cuts in all sorts of things we currently think of as absolutely necessary—like the military, education, and Medicare spending.

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One way or another, the projected budget deficits—whether the one from the Heritage Foundation or the official government projection—are going to come down. We can choose to proactively deal with the deficit problem or we can wait until there is a crisis and be forced to react. These choices will result in entirely different outcomes.

In the US, the real question we must ask ourselves as a nation is, “How much health care do we want, and how do we want to pay for it?” Everything else can be dealt with if we get that basic question answered. We can substantially change health care, along with other discretionary budget items, or we can raise taxes, or some combination. Each path has consequences.

The polls say a large, bipartisan majority of people want to maintain Medicare and other health programs (perhaps reformed), and yet a large bipartisan majority does not want a tax increase. We can’t have it both ways, which means there is a major job of education to be done. But that is also why politicians seem to be advocating both objectives—their first order of business is to make sure they get re-elected.

The point of the exercise, to my mind, is to reduce the deficit over five or six years to some sustainable level below the growth rate of nominal GDP (which includes inflation). A country can run a deficit below that rate forever, without endangering its economic survival. While it may be wiser to run some surpluses and pay down debt, if you keep your fiscal deficits lower than income growth, over time the debt becomes less of an issue.

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Basic Economics
Either raising taxes or cutting spending has side effects that cannot be ignored. Either one or both will make it more difficult for the economy to grow. As a reminder to long-time readers and a quick intro to new readers, let’s quickly look at a basic economic equation:

GDP = C + I + G + Net Exports, or GDP is equal to Consumption (Consumer and Business) + Investment + Government Spending + Net Exports (Exports - Imports). This is true for all times and countries.

Now, what typically happens in a business-cycle recession—as businesses produce too many goods and start to cut back—is that consumption falls. The Keynesian response is to increase government spending in order to assist the economy to start buying and spending.

The theory is that when the economy recovers, you can reduce government spending as a percentage of the economy and pay down the borrowed debt—except that has not happened for a long, long time. Government spending has just kept going up for decades.

Sometimes taxes would rise faster than spending, as during the all-too-brief Clinton-Gingrich years. In response to the Great Recession, government (both parties) increased spending massively. And it did have an effect. But it wasn’t just the stimulus, it was the absolute size of government relative to GDP that increased as well.

And now massive deficits are projected for a very long time, unless we make major changes. The problem is that taking away that deficit spending is going to have the reverse effect of the stimulus—a negative stimulus, if you will.

Why? Because the economy is not growing fast enough to overcome the loss of that stimulus. We will notice it. It is the “G” component of the above equation, which was first developed by Irving Fisher during the Great Depression. The negative stimulus should be a short-term effect —most economists agree it will last four or five quarters—and then the economy may be better, with lower deficits and smaller government.

In order to get the deficit under control, we are talking about reducing the deficit on the order of 1% of GDP every year for five or six years. That is a very large headwind on growth, especially in a 2% Muddle Through economy.

GDP for the US is now on an anemic 2% growth trend, with very weak final demand. Think what it would be if the full anticipated 2% of spending cuts and tax increases were put into force. It would be very hard to attain positive growth in 2013.

Furthermore, tax increases reduce GDP by anywhere from one to three times the size of the increase, depending on which academic study you favor. Large tax increases will inevitably reduce GDP and potential GDP. That may be the price we want to pay as a country, but we need to recognize that there will be a cost to growth and employment.

Those who argue that taking away the Bush tax cuts will have no effect on the economy are simply not dealing with the facts, based on well-established research. And that is different from the argument that says we should allow the cuts to expire anyway.

Those who argue that reducing spending will also have an effect are equally correct. Government has been a large contributor to consumer income and therefore personal consumption, part of the “C” in the above equation (along with business consumption).

There are no easy choices. If we do nothing about the deficit, we will quickly find ourselves close to the black hole of too much debt. Yet trying to do too much too quickly will bring the economy perilously close to recession, which will mean increased government expenses and decreased revenues, making it hard to balance the budget.

Forget Greece and Spain—ask the United Kingdom how well their austerity efforts are doing. This is a country making a serious and credible attempt to reduce their deficits, and sadly, they have fallen back into recession.

No matter what economists with their models and politicians with their agendas will try to tell you, there is no “easy button.” While there may be a correct path to reducing the deficit and keeping us out of recession, that path is not going to be clear from the models. What we will hopefully do is get the direction correct and ease slowly into confronting the deficit-reduction facts.

My thought is that if there are going to be tax increases and spending cuts, they should be phased in quarter by quarter. It might be better to simply hold the line on spending on all but essential items, cutting spending where possible to allow for spending growth in areas like health care. The bond market will behave as long as Congress defines a very clear and credible path to a manageable deficit.

Both Republicans and Democrats will have to compromise. This election is primarily about the direction of the compromise. It is my sincere hope that both parties do not waste this crisis. There will be no better time to engage in comprehensive tax reform than the first six months of next year.

True tax reform could actually be a significant stimulus to the economy and partially offset the drag of reducing the deficit. Tax reform in combination with a serious energy policy that encourages more rapid expansion of domestic production, plus control of health-care expenditures, will let us reduce the “fiscal multiplier”—especially important, given that monetary policy is severely constrained with interest rates at the zero bound.

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