In layman’s terms please!
Let it first be noted, there is no way I can do justice to this topic in a six hundred word column. That being said, I think there is merit to removing some complexity for a high level overview most of us can relate to.
In short, the situation is this: The US Government has way overspent. They are in a huge amount of debt and in jeopardy of not being able to pay their bills. In deciding how to deal with this situation, they try to figure out ways to reduce spending (budget cuts) and increase revenue (tax hikes) but each ‘solution’ is less than ideal and has ramifications on their economy and potential hardships for citizens.
When most of us look at the numbers published in the media like “US debt 16.4 trillion and counting”, our eyes gloss over because its relevance is hard to put into perspective. I recently received a US Fiscal Cliff summary that takes the US debt and revenue numbers and reduces them down proportionately in terms we can better understand.
For illustration purposes, if the US was one person, here is what their personal financials would look like:
Net Annual Income $ 21,700 (relative to US Tax Revenue)
Annual Expenses $ 38,200 (relative to US Federal Budget)
New Annual Debt on Credit Card $ 16,500 (relative to US New Annual Debt)
Total Debt existing on Credit Card $142,710 (relative to US National Debt)
Expense reduction so far $ 385 (relative to recent US budget cuts)
You are no doubt reading this with your jaw on the floor. We can clearly see that $142,710 in credit card debt, and annual spending that nearly doubles income is a big red flag for an individual - enormous. Here is where the debt ceiling comes in.
The debt ceiling is a self-imposed law created to manage debt levels. It represents the maximum amount of money the government can borrow at any given point in time. A new debt ceiling was negotiated in the summer of 2011 as the US was about to surpass this limit and will most likely need to be renegotiated again in May.
The Budget control act of 2011 called for tax hikes and spending cuts, both scheduled to happen at the same time. From this, the term ‘Fiscal Cliff’ came to be. There was much fear that implementing tax hikes and spending cuts at the same time would cause turmoil and instability in the US financial markets and economy.
Is the “cliff” real, or just hype? As financial writer Thomas Kenny noted, “it’s important to keep in mind that the concept of “going over the cliff” was largely a media creation, since the failure to reach a deal by December 31 never ensured that a recession and financial market crash would occur.”
None-the-less, tax hikes were implemented and spending cuts were postponed until March as a temporary measure to reduce the immediate impact and, as some would say, avert the fiscal cliff.
It is important to remember that a country is different from an individual in many complex ways; one of which is the understanding that government spending is also a tool used to stimulate the economy. There are so many variables to manage economic growth. Tax hikes and spending cuts help reduce the deficit but on the flip side, they also reduce consumer spending which has a negative effect on the GDP which slows US growth, jobs, etc. Striking a balance is hard at the best of times, let alone carrying the burden of this much debt.
The US, while still strong in many areas, and whose blue chip companies are looked favourably upon by many investment managers, indeed has its work cut out for it to get their national deficit back under control.
Stephanie Farrow, B.A., CFP., Stephanie has over 20 years experience in the financial services industry, a diploma in Financial Planning from the Canadian Institute of Financial Planning, and Certified Financial Planner designation. Stephanie has been writing a financial planning column for the local business magazine Elgin This Month since 2010 and hosts our Farrow Financial Blog and Twitter @farrowfinancial. Stephanie and her husband Ken Farrow own Farrow Financial Services Inc., are busy raising three young children and actively involved in the community. Our Financial Services Team.