What is the "Fiscal Cliff" and what does it mean to you Part I

This Fiscal Cliff has been mentioned in the news quite a bit lately, but most Americans barely have an understanding of what it is or what it means to them. This is mostly because the news uses economic jargon and many of the articles are difficult to read. Here I will make an attempt to explain it is a way most readers should be able to understand and relate to.

I will start with an example:

Imagine a family who has a household income of $40,000. Now imagine they want to increase their standard of living a bit, have a nice vacation, and maybe buy some new furniture. They choose to accept an offer from their bank for a $10,000 credit card and they use the whole thing in one year. They have now lived for one year as if they made $50,000.

The next three years they do the same thing with another bank each year, again, living on $40,000 and +$10,000 in borrowed money each year, they choose to not give up the lifestyle, in exchange for a little more debt each year.

Year 4 however they now have the same $40,000 income, but they owe $40,000 in debt. The credit card payments add up to $15,000 which brings their disposable income DOWN to $25,000. If they want to live like they make $50,000 a year, now they would need to borrow $25,000 more each year.

In this situation the “Fiscal Cliff” is the moment that the family MUST choose to begin paying off their debt. They need to reduce their borrowing, AND at the same time, find extra income AND reduce their spending. They MUST do all three things if they wish to maintain a similar standard of living AND avoid a bankruptcy scenario.

Okay hopefully you understand that story. People obviously cannot continue to increase there debt forever without paying it off or balancing their budget. And that is precisely where the US is right now.

That DANGER of the fiscal cliff comes from how weak our economy is right now, and how the combination of tax increases, spending cuts, and a slice of our GDP going to reducing the deficit is what worries many economists.

I will go into more detail about these pieces in part II, but to sum it up, Growing the Economy means Growing Gross Domestic Product (GDP). GDP is (Exports – Imports) + Government Spending + Investment + Private Spending. By raising taxes, you move money out of private spending and investment and traditionally move it into Government Spending. However in this special case, we are ALSO reducing Government Spending. it is feared we will actually shrink our GDP, when we really need to be growing it.

Back to our example, if you look at this families contribution to society as the original $40,000 in income they made in year one. In year two through four, they contributed $50,000 to society because they borrowed money. In year five, they can only contribute $25,000 to society because they MUST pay $15,000 to their debt.

It is difficult in this example to illustrate taxes, but essentially imagine their neighbors gift them some money ($10,000). This money is $10,000 less that their neighbors are contributing to society, and it is also not being contributed to society by our example family because is its instead being used to reduce their deficit.

Political partisanship aside, this is a serious issue which needs to be resolved in our country. Our current interest payments on our debt make up almost half of our yearly budget. All of those payments do nothing to improve growth and are essentially wasted dollars.

Families in America are bound by laws which require them to live within their means, if they stray too far they face legal action, and bankruptcy. Right now and for the past 12 years our government has lived far outside its means, and this “Fiscal Cliff” is the first in a long struggle to get us back on the right path.

Thank you for reading and I will post again soon!

George.