Why We Should’ve Jumped Off the Fiscal Cliff

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January 4, 2013 12:53pm NYSE:IEF NYSE:SHY

Martin Hutchinson: In the end, a last-minute deal emerged. Just like that, the fiscal cliff crisis was averted. 

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.

Here’s why…

Why We Should’ve Jumped Off the Fiscal Cliff

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.

More Trillion Dollar Deficits

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 U.S. would become Greece on a gigantic scale.

However, it’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.

For investors, the message is clear. Avoid Treasury bonds, maybe even go short. Keep a position in stocks, especially in Canada, Australia and emerging markets where policies are not so foolish as in the U.S., Europe and Japan. And buy precious metals.

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

Related Tickers: ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT),  iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF), ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF), iShares Barclays 20+ Year Treas Bond ETF (NYSEARCA:TLT), Barclays 1-3 Year Treasury Bond ETF (NYSEARCA:SHY).

Written By Martin Hutchinson From Money Morning

Martin is a Contributing Editor to both the Money Map Report and Money Morning. An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. At Creditanstalt-Bankverein, Hutchinson was a Senior Vice President in charge of the institution’s derivative operations, one of the most challenging units to run. He also served as a director of Gestion Integral de Negocios, a Spanish private-equity firm, and as an advisor  to the Korean conglomerate, Sunkyong Corp. In February 2000, as part of  the Financial Services Volunteer Corps, Hutchinson became an advisor to  the Republic of Macedonia, working directly with Minister of Finance Nikola Gruevski (now that country’s Prime Minister). The nation had been staggered by the breakup of Yugoslavia – in which 800,000 Macedonians lost their life savings – and then the Kosovo War. Under Hutchinson’s guidance, the country issued 12-year bonds, and created a market for the bonds to trade. The bottom line: Macedonians were able to sell their bonds for cash, and many recouped more than three-quarters of what  they’d lost – to the tune of about $1 billion. Hutchinson earned his undergraduate degree in mathematics from Cambridge University, and an MBA from Harvard University. He lives near Washington, D.C.

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