As the clock winds down on 2012, the Fiscal Cliff is all anyone seems capable of discussing. Right now it appears that some sort of narrow deal has just emerged that will include raising tax rates on family income over $450,000 a year, increasing the estate tax rate, extending unemployment benefits for one year, and delaying spending cuts.
But the prospect of higher taxes and the great uncertainty that has surrounded this fiscal fiasco has been acting like sand in the gears of the complex but sputtering U.S. economy. If additional taxes are not matched by real cuts in government spending, the economically crippling tax increases will serve merely to increase the size and intrusive power of big government. In other words, the pain will yield no gain.
But the damage to the U.S. economy will result not so much from the actual cuts and tax increases that the Cliff would involve, but from blatant dereliction of duty on display in Washington which will diminish national prestige.
To some, a loss of reputation may seem to be an ephemeral and ultimately insignificant economic cost. However, the spectacle of American politicians failing to agree on budgets, spending limits, or any type of fiscal discipline can affect the credit rating of the U.S. Over the longer term, a major fall in the credit rating is likely to increase U.S. interest rates. This would add further to the pressure on U.S. debt and render the U.S. Treasury bond market as one of the greatest financial bear traps in history.
Even more threatening than the Fiscal Cliff is the far higher and steeper Entitlement Cliff, which dwarfs the Fiscal Cliff in almost every dimension. America's massive baby boom generation began entering retirement last year. As increasing numbers of workers retire over the next decade, significant strains will be placed on Social Security and Medicare, America's entitlement monoliths. It is no understatement to say that if the finances of these programs are not brought into balance, the United States will be brought to its knees financially.
Yet both parties in Washington appear content to ignore these problems. A very modest proposal by Republicans to trim Social Security expenditures (by cravenly tinkering with inflation calculations) was withdrawn almost as soon as it was introduced.
But in truth, anything short of a comprehensive resolution of the Entitlement Cliff threatens to sap the economic prospects of the United States for generations to come. At present, however, the U.S. dollar, despite its inherent fatal flaws, continues to be perceived by many as the 'currency of refuge'. In contrast, the euro, although protected somewhat by central banks, does not enjoy the full status of an international reserve currency. Therefore, the Eurozone has been forced by the financial markets to jump off the cliff and endure economic austerity.
This privileged position has conferred on Washington the vital element of time to organize viable revisions to its entitlements. As a result, plans could be made to coordinate the restructuring and reduction of government spending, borrowing and taxation. A wise government could be looking to make an orderly descent from the top of the cliff, making provisions for solid footing and safety lines. But alas, this opportunity has been left unexplored.
Though a short-term fix may have been reached, the Entitlement Cliff still looms large and descending down this precipice could seal the fate of the U.S. dollar. As a result, the ability of U.S. politicians to deal with entitlement spending will have global economic consequences of the highest order.
The shockwaves of miscalculations if made by American politicians could reverberate around the world, affecting international financial markets and threatening the continued viability of fiat currencies.
John Browne is a Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.
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