What is the fiscal cliff?

Fiscal cliff or United States fiscal cliff is shorthand term used to describe the effect of a series of enacted legislation which will automatically take effect at midnight on December 31, 2012 as tax increases and spending cuts to reduce the US budget deficit and slow down the growth of US debt. As it happened in United States debt-ceiling crisis in 2011, where a financial crisis started as a debate in the United States Congress about increasing the debt ceiling, the US Congress kicked the can until the very end and let the US economy to come just to the edge of this cliff. So if nothing is done - and nothing is done until this very last months of 2012, taxes will go up and there will be huge spending cuts. Many economists predicts that this will result in a new recession. And US debt situation is so desperate that even all these new tax increases and spending cuts take effect, they will only slow down the growth of US debt.

So within a few weeks, after the new President of The United States is elected, there will be very large debate will erupt in Congress about how to deal with the “Fiscal Cliff” and both sides of the debate will argue that their solution is the best when the other solution is an absolute disaster.

So what is the fiscal cliff? In the The Perils of the Fiscal Cliff [1]  article, John Mauldin explains:

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.[2] 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.

In the video below, David Wessel from Wall Street Journal explains things you need to know about the "fiscal cliff". As he explains the real problem is the US budget (or budget deficit):

"Like any budget, money comes in and money goes out. And more money goes out than comes in, there is a budget deficit. I think we have made things way way to complicated. Let me give you 6 facts about the federal budget, which is pretty much all you need to know:

1 - In 2011, 63% of the all federal spending was on auto-pilot. The money went out the door without any voting in Congress to pay the promises made in the past. To pay social security benefits, medicare benefits for elderly, medicaid for the poor, farm subsidies and of course the interest on the federal debt. 

2 - 1 out of every 4 dollars spend from Us budget goes to healthcare. In 1960, before Medicare and Medicaid, healthcare was less than 10% of the US Federal spending. Today, in 2012, it is 25%. 10 years later, it will hit 33%. 

3 - A lot of people think that US government employs a lot of people and they are right. 4 million people work for the US government. But the fact is, if you fired every single one off them, from the secret service agents standing next to the President to the lady collecting tolls for tickets in Yellow Stone and soldiers in Afghanistan, you save 435 billion dollar in a year. That would not reduce the deficit even 1/3. The point: Closing down federal agencies can save some money: but not nearly enough to solve the problem. 

4 - US spends a lot of money on defense: 700 billion USD only in 2011! That is 1 out of every 5 dollars the US government spends. US defense budget is bigger than the combined defense budget of the next 17 big defense spenders: China, Britain, France, Russia, Saudi Arabia, Japan, Germany, India, Italy, Brazil, South Korea, Australia, Canada, Turkey, U.A.E, Spain and Israel. 

5 - Federal income taxes have been falling for more than 30 years. In 1981, the middle class has paid 19.2% of their income as tax. In 2007, that percentage was 14.3%. So how the government has managed to spend more and more? First, the rich paid more taxes as they have made more income. And US have borrowed! US government has borrowed 36 cents for every dollars spend."

So if you decide how much to spend on benefits, healtcare, how many workers government should employ , how much US should spend on defense and how much tax should people pay, you solve the US debt problem. Everything else is detail. But sorting all these out is the problem because people have different views of the solutions for the very same problem and they cannot decide on the solutions.

There is no good solution to the US fiscal cliff: with huge us debt still growing, there are bad and worse choices. If US does not start to reduce the budget deficit now as the fiscal cliff or as some sort of other solutions, a time will come when the US deficit will be so high and countries lending money to US will require very high interest rates: The result: forceful spending cuts in almost everything. So the question is like do you get some pain today (as a recession) to avoid a big torture in the near future (a great depression) or do you try to postpone the pain and face the torture in the future.  I believe US, as Europe and Japan, will find a solution to the immediate fiscal cliff problem by kicking the can down the road more and  doing absolutely nothing to address the real structural problems. As John Mauldin repeatedly says, Japan is a bug in search of a wind shield and in my opinion Europe and US are fast going to that craze point. [1] - The perils of the fiscal cliff [2] - Refer to United States debt-ceiling crisis