July 10, 2012 By Peter Schiff     July 10, 2012The media is now fixated on an apparently new feature dominating the economic landscape: a “fiscal cliff” from which the United States will fall in January 2013. They see the danger arising from the simultaneous implementation of the $2 trillion in automatic spending cuts (spread over 10 years) agreed to in last year’s debt ceiling vote and the expiration of the Bush-era tax cuts. The economists to whom most reporters listen warn that the combined impact of reduced government spending and higher taxes will slow the “recovery” and perhaps send the economy back into recession. While there is indeed much to worry about in our economy, this particular cliff is not high on the list.

Much of the fear stems from the false premise that government spending generates economic growth (for stories of countries experiencing real growth, see our latest newsletter). People tend to forget that the government can only get money from taxing, borrowing, or printing. Nothing the government spends comes for free. Money taxed or borrowed is taken out of the private sector, where it could have been used more productively. Printed money merely creates inflation. So the automatic spending cuts, to the extent they are actually allowed to go into effect, will promote economic growth not prevent it. Even most Republicans fall for the canard that spending can help the economy in general. But even those who don’t will surely do everything to avoid the political backlash from citizens on the losing end of any specific cuts.

The only reason the automatic spending cuts exist at all is that Congress lacked the integrity to identify specifics. Rest assured that Congress will likely engineer yet another escape hatch when it finds itself backed into a corner again. Repealing the cuts before they are even implemented will render laughable any subsequent deficit reduction plans. But politicians would always rather face frustration for inaction than outright anger for actual decisions. In truth though, only an extremely small portion of the cuts are scheduled to occur in 2013 anyway. If it comes to pass that Congress cannot even keep its spending cut promises for one year, how can they be expected to do so for ten?

The impact of the expiring Bush-era tax cuts is much harder to access. The adverse effects of the tax hikes could be offset by the benefits of reduced government borrowing (provided that the taxes actually result in increased revenue). But given the negative incentives created by higher marginal tax rates, particularly as they impact savings and capital investment, increased rates may actually result in less revenue, thereby widening the budget deficit.

In reality, the economy will encounter extremely dangerous terrain whether or not Congress figures out a way to wriggle out of the 2013 budgetary straightjacket. The debt burden that the United Stated will face when interest rates rise presents a much larger “fiscal cliff.” Unfortunately, no one is talking about that one.

The current national debt is about $16 trillion (this is just the funded portion…the unfunded liabilities of the Treasury are much, much larger). The only reason the United States is able to service this staggering level of debt is that the currently low interest rate on government debt (now below 2 per cent) keeps debt service payments to a relatively manageable $300 billion per year.

On the current trajectory the national debt will likely hit $20 trillion in a few years. If by that time interest rates were to return to some semblance of historic normalcy, say 5 per cent, interest payments on the debt would then run $1 trillion per year. This sum could represent almost 40 per cent of total federal revenues in 2012!

In addition to making the debt service unmanageable, higher rates would depress economic activity, thereby slowing tax collection and requiring increased government spending. This would increase the budget deficits further, putting even more upward pressure on interest rates. Higher mortgage rates and increased unemployment will put renewed downward pressure on home prices, perhaps leading to another large wave of foreclosures. My guess is that losses on government insured mortgages alone could add several hundred billion more to annual budget deficits. When all of these factors are taken into account, I believe that annual budget deficits could quickly approach, and exceed, $3 trillion. All this could be in the cards if interest rates were to approach a modest five per cent.

If the sheer enormity of the red ink were to finally worry our creditors, five per cent interest rates could quickly rise to ten. At those rates, the annual cost to pay the interest on the national debt could equal all federal tax revenues combined. If that occurs we will have to either slash federal spending across the board (including cuts to politically sensitive entitlements), raise taxes significantly on the poor and middle class (as well as the rich), default on the debt, or hit everyone with the sustained impact of high inflation. Now that’s a real fiscal cliff!

By foolishly borrowing so heavily when interest rates are low, our government is driving us toward this cliff with its eyes firmly glued to the rear view mirror (much as the new French regime appears to be doing). For years I have warned that a financial crisis would be triggered by the popping of the real estate bubble. My warnings were routinely ignored based on the near universal assumption that real estate prices would never fall. My warnings about the real fiscal cliff are also being ignored because of a similarly false premise that interest rates can never rise. However, if history can be a guide, we should view the current period of ultra-low rates as the exception rather than the rule.

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The US Debt will not be repaid

These are times that try an asset manager’s soul. The world’s economy is a soft-paste porcelain vase set on a wobbly plant stand in the heart of an active earthquake zone. The Middle East is sending out foreshocks of war. The South China Sea is a smoking caldera of tension. Social unrest in the EU threatens tidal waves. And, according to the agitated rats and snakes of the financial press, China is headed into a recession.

Meanwhile, in the U.S., where the economy is climbing from its financial crater like an underoxygenated mountaineer, congressional miscalculation threatens to topple the weary cragsman back into the abyss.

Hedging against the most pessimistic case without crippling the upside potential of a better or even miraculous case appears to be as unsolvable as the proverbial Gordian knot. Alexander the Great “solved” the intellectually challenging knot riddle by severing it with his sword. Scott Minerd, chief investment officer of Guggenheim Partners, offers a more reasoned but equally simple solution to the hedging conundrum: gold. In extreme circumstances—like miscalculations regarding inflation by the Federal Reserve—the metal could hit $10,000 per troy ounce, he asserts. Thursday, after the Fed disclosed its latest financial-stimulus scheme, the metal rose about 2% to $1,768.

Most economists aren’t forecasting a recession or inflation for the U.S. A sudden acceleration of domestic economic activity leading to a more robust recovery doesn’t seem to be in the cards either, assuming that President Obama is re-elected and continues to focus on income redistribution as opposed to job growth.

Martin Regalia, chief economist for the U.S. Chamber of Commerce, says that, based on current patterns, underlined in the most recent employment report from the Bureau of Labor Statistics, a full jobs recovery will take another five years. With growth below 3%, the economy is creating just enough jobs to absorb new entrants into the labor market, not provide work for everyone who was laid off in the 2007-2008 credit-market crash, he says. They number about seven million. Anemic income growth also is a drag. As the nearby charts show, Americans strapped with debt aren’t bringing home enough money to significantly reduce their debts. The low rates engineered by the Fed merely make it easier for them to service that debt. So much, then, for a consumer-led recovery.

Regalia worries that miscalculations by a bickering Congress in tackling the $16 trillion federal debt or avoiding the “fiscal cliff” might cause chary foreigners to rethink lending to the U.S. at rates near zero. Absent serious belt-tightening, America probably would inflate its way out of debt. For every 1% increase in rates that would be demanded under such circumstances, $100 billion would be added to the budget deficit. In normal times, the foreign lenders would demand at least 3%, says Regalia.

Minerd frets about the Fed’s ability to reduce its swollen $2.9 trillion balance sheet if rates suddenly were to rise. Because the assets have longer-term durations, their market value immediately would tumble. If rates rose 1%, the Fed would have a $150 billion capital deficit, he says. This would have negative ramifications for the dollar. Minerd says the über-wealthy have been migrating toward hard assets like gold, real estate, and art. Every portfolio should be partially composed of such assets, he asserts. Is yours?

E-mail: jim.mctague@barrons.com