“Uh oh! We better stay on the current path.”

Even before the last balloon hit the floor at President Obama’s victory party, the media had already shifted its focus to the looming fiscal cliff. The chorus call from the mainstream media is that our political leaders need to “come together” to “compromise” so that we can avoid going over the cliff. Failure to avoid the cliff, they say, will be a disaster.

But what exactly is the fiscal cliff? It’s a roughly $600 billion yearly deficit reduction through tax increases and discretionary spending cuts starting in 2013. To be more specific, it’s about $400B in tax increases, $100B in spending cuts that aren’t actually cuts but a reduction in the amount the spending will increase, and about $100B of estimated revenue from economic growth. You can find out the exact numbers elsewhere. Wikipedia has a good summary. The purpose of this post is to add some perspective on what the fiscal cliff really means in the greater scheme of things.

The best way to think of the fiscal cliff is as follows: The politicians, with the tacit approval of the voters, have created a government which now spends $3.8 trillion a year in on-budget spending. In fiscal year 2012, the government collected $2.47T in revenue which means they had to borrow $1.33T to pay for the rest. The fiscal cliff simply means that Americans will have to pay a bit more out of pocket for the government they are getting each year instead of putting it on a credit card.

“Well that seems reasonable,” you might say, “so why is the financial world so terrified?” They are terrified because the economy is already weak and the increased taxes and decreased spending from the government sector will cause a drop in the GDP, sending us back into a recession. (On a side note, the fact that actually trying to pay for our government causes such pain proves just how out of control our spending really is.)

The media, politicians and mainstream economists are obsessed with the economic indicator known as the GDP. Unfortunately, as I explained in an earlier post titled Government Numbers, GDP is simply one metric of economic health, and a pretty bad one at that. If they insist on just looking at GDP, I would suggest they should look at what I call SGDP, or Sustainable GDP. As I plan to describe in a future post, SGDP is calculated by subtracting out the increase in government debt from the GDP to determine the economic activity that was generated without stealing from the future. If you look at SGDP we are already in a massive recession and have been for years.

“Ok, so how did we get into this mess called the fiscal cliff?” If you recall, back in 2011, there was a debate in Congress about raising the debt ceiling. Some of the more fiscal conservatives realized that if we just raised the debt ceiling without providing any measures to work towards reducing the deficit in the future, the ratings agencies and lenders might catch on that we have no intention and no ability to pay back our debt. So Congress agreed that they would try to agree on some deficit reduction measures, and if they couldn’t reach a compromise they would bind themselves (actually future congresses) to automatic spending cuts and tax increases. Well, Congress failed to reach an agreement and the fiscal cliff is simply those binding cuts going into affect. Or, as Peter Schiff aptly pointed out, the fiscal cliff is the can we kicked down the road back in 2011. We just caught up to the can. Ironically, we caught up to it just as the new debt ceiling is about to be reached.

“So what should we do?” I actually agree with the media that Congress does need to do something to “fix” the fiscal cliff, although my idea of fixing it is probably different then theirs. Both the Republicans and Democrats (and I) agree that raising taxes on the bottom 98% of taxpayers would hurt the economy. The Republicans (and I) argue that raising taxes on the top 2% also hurts the economy and probably to a greater degree. Unfortunately, their idea of compromise is that we won’t get any more spending cuts to balance out the $400T in lost revenue, and we will delay any tax increases and push spending cuts out into the future kicking the can down the road once again.

More importantly, as the cartoon above depicts, the fiscal cliff is simply a small bump in the road in the grand scheme of things. Fiscal cliff or no fiscal cliff, the debt will continue to rise until we hit what Schiff calls the “real fiscal cliff.” That is the point when our government can no longer continue to borrow, not because of a self-imposed debt ceiling, but because people and governments are no longer willing to lend to an insolvent institution at negative real interest rates.

At that point, the Federal Reserve can either let interest rates rise to meet the market or they can keep rates low by becoming the lender of only resort. If interest rates rise, the interest payments on our massive short-term national debt will rise substantially, assuming a larger and larger percent of the federal budget, and may even eclipse all federal tax revenue. If the Fed keeps rates low by buying Treasuries, it will jack up inflation, destroying the purchasing power of every American who holds dollars. Either way, we are coming to the end of the road.

[Editors note: This is my first attempt at my own political cartoon. I hope you like it. Feedback welcome.]