Fiscal cliff is a term being saturated in the media. While no polls are out on this topic, it is likely that the vast majority of Americans have heard of the term, whether people understand what it means is another question. However, a much bigger problem is coming up shortly, which is being ignored by both the media and our politicians,  the deficit ceiling. Google trends confirms this fact as the chart below shows.

fiscal cliff debt ceiling

According to a recent article The Wall Street Journal,  the Government is now within a month of bumping into the ceiling, which happens to be only several days after the fiscal cliff (it could even occur before the fiscal cliff).

Which would be worse for the economy? I would argue that if US politicians were unable to reach an agreement over the debt ceiling, the consequences would be far worse.

Let us take a look at the two matters. The fiscal cliff is a set of automatic spending cuts and tax increases, set to kick in December 31st, 2012, unless a deal is reached in DC. Nearly all economists agree that the result of ‘going over’ the fiscal cliff would lead to a recession.

A look at the Fiscal cliff, what if we go over it?

‘Acording to an analysis by J.P. Morgan economist Michael Feroli, $280 billion would be pulled out of the economy by the sunsetting of the Bush tax cuts; $125 billion from the expiration of the Obama payroll-tax holiday; $40 billion from the expiration of emergency unemployment benefits; and $98 billion from Budget Control Act spending cuts. In all, the tax increases and spending cuts make up about 3.5% of GDP, with the Bush tax cuts making up about half of that, according to the J.P. Morgan report.” The CBO estimates that going over the cliff would result in a 4% GDP drop. With GDP growing at sub 2%, this would likely mean a contraction in GDP, or a recession. However, the US does go through recessions every few years and emerges eventually. So the worst case scenario is a contracting economy, followed by a recovery.

Furthermore, not all of these cuts and tax hikes go into effect at once. They take place over a time period, so it is not all or nothing. The impact will not happen all in one night, but rather over time, so perhaps it would not harm the economy as many suggest. Some are even suggesting that an agreement will be reached after December 31st.

Additionally, there is a silver lining for the deficit hawks. Going over the fiscal cliff is expected to reduce the deficit. The reason being, that the tax increases and spending cuts will reduce the budget deficit. The CBO forecasts that going over the fiscal cliff would reduce the deficit by approximately $560 billion.

In terms of the fiscal cliff, while most people think it would be negative to leave unresolved, some people would think its positive (unrelated to political issues). Therefore, it is debatable about whether this is a bad thing at all.

Now let us move onto the debt ceiling, this scenario is frightening. The US has a law which limits how much debt the Government could amass. In August 2011, after long negotiations (which led to the fiscal cliff scenario), the GOP and Barack Obama reached a deal to increase the debt ceiling by an additional $2.1 trillion. In a few weeks, the US is expected to hit the new limit of $16.394 trillion. What happens when we hit that level?

There is little discussion in the media, despite the dire consequences of going over the debt ceiling. However, the debt ceiling was a big talk of the media during the summer of 2011. What would happen is that the US would not be able to issue debt. However, even for deficit hawks toying with the debt ceiling is dangerous. If someone wants to cut the debt drastically, they are entitled to that opinion, but to stop the US from issuing debt overnight will lead to the following:

A US default on its debt, assuming the Treasury decides not to spend its money on creditors. This would be disastrous, as  no one would trust the US Government any more . While the Federal Reserve would eventually be able to buy all the debt it wants, it is extremely unlikely any foreign investors or even domestic investors would buy US Treasuries.

The US was downgraded, which does not seem to really matter, but to some its important.

The Treasury Department at the time warned that “failing to increase the debt limit would . . . cause the government to default on its legal obligations – an unprecedented event in American history.”

Social Security would not be paid, neither would Medicare,  military salaries, etc. This would likely lead to such a massive loss in both disposable income and consumer confidence that spending would tank and lead to a far worse depression, especially as 65% of US GDP comes from consumer spending.

The WSJ stated in the summer of 2011, that the US had a plan which would pay foreign creditors before items like social security. It takes little imagination to think about riots when people who worked for forty years do not get their hard earned social security checks, while China gets the money. It will lead to lawsuits at best, and full scale riots at worse.

While the Fiscal cliff is a big deal, it is time for the media, lawmakers, and average Americans to start preparing for the debt ceiling. Going over the fiscal cliff would be painful, but getting to the debt ceiling would be disastrous.