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Why the Fiscal Cliff Deal is Bad News

The fiscal cliff deal is worse than the cliff itself...

AND SO, a last-minute deal emerged. Just like that, the fiscal cliff crisis was averted, writes Martin Hutchinson for Money Morning.

In the waning hours of New Year's Day, Congress voted to avoid a large package of tax increases, along with some modest spending cuts. Not surprisingly, the markets just loved it. The Dow soared over 200 points on the open and never looked back.   

But first, let's call this deal what it is: a late-day compromise that failed to address serious fiscal issues. In the end, the agreement reached on Tuesday night will only reduce the deficit by about $60 billion annually over the next 10 years.  

That's less than 10% of the total projected deficits, which means well before 2020 we will likely have a real crisis on our hands. 

But the real story in this mess is this: the cold hard truth is that going over the cliff would have actually been beneficial.  And despite the promises of Keynesian economists, the deal that emerged was not an improvement.

In reality, the predictions of doom that surrounded the fiscal cliff were made to achieve a political goal, and we should have ignored them. 

First, let's deal with the unpleasantness up-front. Paying higher taxes is a pain, and the fiscal cliff would have raised taxes on everybody, not just on the "rich" with incomes of $250,000 a year. In the new deal, the break is at $400,000 for individuals and $450,000 for couples. 

Of course, in an ideal situation, the government would have cut spending from its current bloated levels, returning spending to its long-term average as a percentage of GDP. But let's face it; that would be very difficult. 

New legislation such as the 2001 "No child left behind act," the 2004 Medicare prescription drug entitlement, and Obamacare, as well as the wars in Iraq and Afghanistan, have permanently increased the size of government, while relaxed regulations have allowed 47 million people to draw food stamps, worsening the problem.  

In any case, since we don't have an ideal government – as the fiscal cliff crisis proved yet again – anything more than minor spending cuts are almost impossible to obtain.

The reality is that falling off the "fiscal cliff" had two advantages. First, it solved 77% of the next 10 years' budget deficit problem. The 10-year budget deficit would have been reduced from $10 trillion to $2.3 trillion, according to Congressional Budget Office figures, or annually from an average of $1 trillion to $230 billion. 

The other big advantage of the fiscal cliff was that it increased middle-class taxes, something almost impossible for politicians to do directly.  That's important. 

You see, for years voters have been getting $1 trillion more in government services than they have paid for, with Ben Bernanke financing the difference at rates below the inflation rate (hence negative in real terms.) 

Naturally, voters like this and vote for more free largesse.  But this needs to be stopped; the country simply cannot afford to run continual $1 trillion deficits, imposing huge liabilities on our grandchildren, and the deficits cannot be closed by increasing taxes only on the rich. 

Using middle-class taxes to force voters to pay for the bloated government they support in the polling booth is essential to the health of American democracy. 

In reality, spending must be paid for on a current basis, so that the electorate can realize its cost. The fiscal cliff achieved this; the compromise deal doesn't.

Now, with Bernanke still in charge, the deficits will continue at close to $1 trillion per annum until the bond markets refuse to accept Treasuries. You can't imagine the recession THAT would cause.  The US would become Greece on a gigantic scale. That's beginning to appear inevitable, though probably not in 2013.

What's more, the fiscal cliff would have only caused a minor slowing in the economy, because the reallocation of resources would have been so sudden. 

However, after the first few months, the $700 billion reduction in the budget deficit would have caused long-term interest rates to fall even further, with 10-year Treasuries yielding below 1%.  Plus, the additional $700 billion in taxes paid and spending curtailed would have been matched by an extra $700 billion available in capital markets for non-government uses.

Instead, with the compromise deal, bond yields will rise, as the deficits become obviously more dangerous, and the lack of progress against them becomes more apparent. 

However, the good news is the equities and commodities markets should enjoy a bounce in the short term, as Ben Bernanke buys enough Treasury and Agency bonds to offset the deficit. With the European Central Bank also buying bonds to support the dodgier economies of southern Europe, and the new Shinzo Abe government in Japan prodding the Bank of Japan to redouble its bond-buying efforts, liquidity in the markets will expand further.

Here's the bottom line: The messy compromise doesn't solve anything.

Time to Buy Gold?...

Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

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