Sleepwalking Closer to the Fiscal Cliff

For investors, the “fiscal cliff” is like the boogeyman, something vaguely frightening that lurks in the dark recesses of their minds. But its danger, as Moody’s Investors Service (NYSE:MCO) noted Tuesday, is all too real.

The ratings agency, which last year retained its top Aaa rating on the U.S. while Standard & Poor’s took the unprecedented step of removing its top AAA rating, said yesterday that it would cut its rating one notch if the “so-called ‘fiscal cliff’ actually materialized.”

Fiscal cliff is a term created by Federal Reserve Chairman Ben Bernanke to describe the confluence of tax hikes and spending cuts set to begin early next year, which the nonpartisan Congressional Budget Office predicts will lead to a recession in 2013. Congress created this cliff during last year’s contentious debate over the debt ceiling. It’s meant to force Washington into making the politically unpopular decisions that everyone agrees must be made but few have the guts to actually make.

Sadly, politicians are punting on the issue instead of tackling it, even though more than 2 million jobs may be at risk.

In a Tuesday press conference in Washington, House Speaker John Boehner said he was “not confident at all” that the fiscal cliff could be avoided. A recent report from Politico was even more depressing, arguing “the truth is that none of the top leaders or their aides are in serious negotiations” over the fiscal cliff this close to the presidential election.

It’s all too predictable to economists. “There is no reason why they shouldn’t deal with this right now,” said Curtis Dubay, senior tax analyst at the conservative Heritage Foundation, in an interview. “They haven’t got much else on their plate right now.”

Congress needs to get this right. Under the Budget Control Act passed last year, $1.2 trillion in spending would be slashed over the next decade with the first $109 billion taking effect Jan. 2, 2013. The impact of such a draconian budget cut would be disastrous and linger for years.

Earlier this year, Defense Secretary Leon Panetta argued that the mandatory spending cuts would force the Pentagon to shrink the Navy to the smallest it’s been since World War I, slash the Army and Marine Corps to the sizes they were before World War II and create the smallest Air Force in its history.

Defense contractors would undertake massive layoffs in response, the effect of which would ripple throughout the economy. Few people would not feel its effect on some level.

Perhaps no issue better symbolizes the inertia that has crippled Washington than the George W. Bush tax cuts. Enacted in 2001 and 2003, these cuts are set to expire at year-end and would raise rates on more than 100 million Americans, something that Dubay and other fiscal conservatives argue would stifle what little economic growth the U.S. is generating.

The CBO argues that extending the tax cuts only to the middle class — as President Obama advocates — would be more cost effective. According to the CBO, allowing the cuts to expire only for those whose income is more than $250,000 would save the government over $1 trillion over the next decade.

Love them or loathe them, the Bush tax cuts are nothing new, and Congress can’t keep extending them on a temporary basis forever. Wall Street is reacting with growing alarm about this standoff because many companies are holding off on spending until the situation is resolved.

The stakes couldn’t be higher. The U.S. has to decide whether it wants to go down the path of austerity that has brought Europe to its knees or find a way to sensibly encourage economic growth while maintaining fiscal discipline.

Follow Jonathan Berr on Twitter @jdberr.

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