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The Fiscal Cliff refers to a large group of tax increases and smaller budget cuts that are due to take effect in January, 2013, conveniently after the presidential election. The tax increases would be due to the expiration of a patch in the Alternative Minimum Tax, social security tax cuts and the Bush child tax credits. The spending cuts would be considerably smaller than the tax increases and would be divided evenly between defense and non-defense. The Fiscal Cliff was part of a deal worked out by Congress in August, 2011 as part of the bill to increase the federal debt limit. It was agreed that increasing the federal debt would have dire financial impact, as it did in Greece when the debt/GDP ratio exceeded about 120%. Republicans wanted larger cuts and Democrats wanted even larger tax increases so they settled on this. Unless repealed, the net effect will be to increase taxes for the average family by $3,500 (estimate by the non-partisan Tax Policy Center). Single people and those with larger incomes would pay considerably more.

It is generally accepted by most economists and financial experts that the huge tax increases would cause a severe recession in the US. The spending cuts, though relatively small, would also reduce GDP and increase unemployment. Conventional wisdom is that Congress will kick the can down the road and delay implementation of these effects, increasing the total federal debt. Already the Federal Reserve is forced to buy something like 40% of all bonds issued because there are not enough buyers. This monetization of the debt is equivalent to printing money (electronically) and surely leads to inflation. Pundits believe that Congress will take the inflationary way out rather than the recessionary way out. I disagree.

Let's look at what is likely to happen politically if Congress comes to come sort of deal whereby they cancel (or infinitely delay) the tax increases and spending cuts. If they do vote on any sort of deal, whether it is to cancel the tax increases and blow up the deficit, or allow some tax increases and cancel others, then there will be responsibility. Surely either way (tax increases or monetizing the ever-increasing debt), the economy will suffer. Those who voted in favor will be on the hook. Those who voted against can always claim that they had a magical solution that would have made things so much better. Many people like to believe in magic and happy endings, so these claims have a strong appeal. Since Congressmen are very sensitive to perceptions, the risk of doing anything is that they will be blamed for the inevitable economic decline. It's better to do nothing and hide behind the false claims that they would have done it so much better. The lessons of Greece are not lost on US Congressmen; the Greek politicians who voted for "austerity" were mostly thrown out by the voters and a hard-left faction voted in who promised to restore all of the great perks. For this reason, I think that Congress will do nothing and everyone will retain plausible deniability.

If Congress is indeed paralyzed with fear, and takes no action, then the result will be stagflation with a slow economy (due to large tax increases) and inflation (due to the Fed being forced to monetize a larger percentage of a much larger budget deficit). In this environment, people in bonds will be crushed and stocks will do little better as earnings go over the cliff. Better to hide out in commodities for a while, or ETFs linked to commodities: GLD, XLE, MOO.

Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Fiscal Cliff: Pick Your Poison