The Fiscal Us

News everywhere seems to be blaring about the fiscal cliff that we'll supposedly go over unless something is done about it. Let me begin by saying there is no cliff, keep calm and carry on.

Before diving into the fiscal cliff, let's examine why 'fixing it' could become a problem. For a moment, ignore that we're already $16 trillion in debt.

As a nation we have a GDP of $15 Trillion, that means, we produce that much value per year in dollar terms.

Per person then, our value creation is roughly $50,000 per year. 

Let's put it in real terms of a Joe.

Our Joe is earning 50,000 a year. Banks love Joe, an honest and law abiding person who means to repay every single penny with interest. Joe's got a great credit profile, so he enjoys rock bottom interest rates of 2% as well. Life is great. Joe takes on new debt every year to the tune of  $3,666.67. This not a big number Joe thinks. Joe's income is near stagnant, growing at about 2% a year.

Joe thinks he's pretty well off and doesn't do anything about this debt. In 20 years, Joe's earnings have increased to roughly $75,000.00 per year. He's done nothing about his debt over the years and his debt now stands at roughly the same amount of $75,000.00. 

Suddenly, Joe doesn't look as low risk to banks as he did 20 years ago. What's more, he now needs to borrow 5000 a year, because a sizable amount of his borrowing goes to pay interest on the already existing loans. But wait, banks decide that if Joe wants to borrow more, given his addiction to accumulating debt, he's become a lot more riskier, they charge him 4% interest now on his loans. Now when Joe renews his debt, his new interest payments stand at $3000.00 a year, plus the $3,666.67 he needs a year to finance his lifestyle.

Things go rapidly downhill from here. Banks still lend him money, as Joe is honest and pays back interest even if that means he has to borrow more. In five years, his earnings stand at $83000.00.

At this point, Joe owes his bank $109,000.00. Joe is horribly underwater, with no sign of escape.

His bank refuses to renew his debt till he brings it down to acceptable levels.

Joe has two stark choices in front of him. Reduce his spending immediately and live a leaner life style or, declare bankruptcy. Declaring bankruptcy would be easy, but he would ruin his standing in the financial world, and he would not be trusted for a long time to come. Cutting spending is not an easy choice either, it would mean a huge change in Joe's quality of life.

This is our story as a nation. The fiscal cliff is an early call to action to avoid the ultimate cliff that Joe had to face. We as a nation will become Joe in 10 years. The world loves us and wants to give us money for very cheap because there is nowhere else to park capital. This will change. There will be other places. The price of inaction now will be far steeper in the future.

We're already in as much debt as we produce in value every year as a nation. We spend a big amount of money every year paying interest to our debtors. 

The government has two more options that it can legally pursue that Joe can't. It can print more money or it can tax people more.

Printing more money reduces the value of the outstanding debt, but it also makes our debtors sour.

Taxing people more just takes a bigger percentage of value produced by the population. 

However, these two tactics do work in the short term. But neither of these have any value till we cut our expenses.

Will it hurt in the short run? Sure. But, if and only if we curtail expenses in the long run, taxes and printing money in the short run will put us on a sustainable path for the long term.

The fiscal cliff does two things. It reinstates the tax rates from 10 years ago and the payroll tax holiday from 2 years ago, and it cuts spending a little bit too.

Honestly, there is no cliff. It's a made up notion. It's very clever political marketing by Washington to be able to kick the can down the road some more, AND look like heros doing so.

There will be pain, I'm not suggesting otherwise. But pain today will be tolerable to disease tomorrow.