The Independent Market Observer

12/19/12 - The Bigger Picture

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Dec 19, 2012 10:52:01 AM

and tagged Fiscal Cliff

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Over the past couple of weeks, I have been looking at the day-to-day evolution of the fiscal cliff negotiations and spending quite a bit of time talking about trees. When I did the 2013 outlook series, I did a lot of forest gazing, trying to figure out the bigger picture for the economy and the markets. Now is probably a good time to combine the two and look at the bigger picture of the fiscal cliff and what it means for the U.S. government and economy.

First of all, the era of big government really is over. Any of the proposals out there will result in substantial decreases in discretionary spending, which is what most of us think about when we think about the government. Sure, overall spending will continue to increase, but that will come from the demographically driven growth in entitlement spending. In this sense, the Republicans will win a point, as “government” takes a hit, even as they are poised to lose on tax rates and spending.

Second, entitlement spending will have to be controlled. In the words of Herbert Stein, “If something cannot go on forever, it will stop”—and entitlement spending cannot continue on its current path. I suspect that the cuts will have to be made in stealth mode, a conclusion that is only reinforced by the current proposal to index benefit payments by a chained CPI that uses substitution effects, rather than the current CPI. Presented as a technical fix, this will have the effect of lowering benefit increases by an estimated 0.5 percent per year. Over 10 or 20 years, this is serious money. The stealth mode does not always work—AARP, among others, is on the case—but this is the type of change we will be seeing more of.

Other cuts will include raising the qualification ages, which is sort of but not really on the table now, means testing for benefits, and other things that no doubt are even now being formulated in DC. The demographics make this necessary, and the economics add urgency.

Third, even with one and two above, taxes will be going up. The U.S. taxes like a small government country and spends like a big government one. Not sustainable. The scary part about the fiscal cliff is not what happens in the next couple of weeks; it is what has to happen in the future. Regardless of any deal that’s cut, we will be implementing tax increases and spending cuts in line with what is required for the fiscal cliff, or even larger. We don’t have to do it immediately, but we do have to do it in the next couple of years. What that means is that any deal cut now will be a down payment on required future changes.

None of this is to deny the very real positive trends going on, which I have discussed at length. These trends will mitigate the tax and spending changes needed, but they will not eliminate them. Bigger picture, we are no longer living in a tax-cutting, free-spending world, and the more quickly we make that mental adjustment, the more responsibly we can navigate in the new world.

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