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Fiscal Cliff or Not, Prosperity Will Be Elusive in 2013

Rick Newman

As negotiations intensify over tax hikes and spending cuts due to kick in next year, it's worth keeping in mind that there's life after the "fiscal cliff." The problem is, the cliff may cast a longer shadow than many Americans expect.

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One fallacy about the cliff is that the whole drama will end once lawmakers reach a deal over $600 billion in tax hikes and spending cuts due to go into effect at the beginning of 2013. The fact that there's a deadline for a deal--December 31--amplifies the mistaken notion that it will all be over soon.

The reality is that the deadline merely represents the starting point for changes that will affect the economy--and Americans' ability to get ahead--for years to come. That's why the negotiations are so difficult and bitter.

If lawmakers allowed all of the fiscal-cliff provisions to go into effect as scheduled, it would knock about 4 percent off of GDP in 2013, promptly causing a recession. That's why most people think Congress won't let that happen. But the outcome of the cliff negotiations will still affect the economy, no matter what Congress decides, because there are no good choices and doing nothing could end up worse than clipping economic growth a bit.

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The fiscal cliff actually entails at least nine sets of tax hikes, plus spending cuts due to hit hundreds of government agencies. So while Congress probably won't let all of them happen at once, it's likely that some of them will. Morgan Stanley, for instance, estimates that some tax hikes and spending cuts will take effect, cutting GDP by about 1.5 percent in 2013. Since those would be permanent changes, they'd affect the economy year after year, with the effect dissipating over time.

At the moment, the economy is probably growing by less than 1 percent, and most economists expect sluggish growth of about 2 percent in 2013. So a compromise deal on the fiscal cliff would harm the economy just enough to "keep growth stuck in the "Twilight Zone," as Morgan Stanley said in a recent note to investors.

Another possible outcome is a three- to six-month delay in the December 31 deadline, with negotiations next year over a much bigger deal to reform the tax code, revamp costly entitlement programs like Medicare and make other big changes many economists say are needed. But that would still eventually require the same austerity measures that economists are worried about now; it would just put them off for a year or two, which won't do anything to make businesses or investors more optimistic.

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If there is some kind of negotiated deal on the cliff, a relief rally might send stocks upward and generate a bit of newfound optimism, since Washington will have averted the worst-case scenario investors and business are most worried about. But there are still other factors likely to hold back the economy in 2013.

Russ Koesterich, chief investment strategist for BlackRock, points out that growth in personal consumption--which still accounts for roughly two-thirds of the economy--has been weak recently, largely because incomes are barely growing. Holiday shoppers seem to be comfortable spending--so far--but they're also drawing down their savings and probably putting more of their purchases on credit cards.

If shoppers end up overspent at the end of 2012, and there are even mild tax hikes in 2013, consumers would probably face another year of frugality as they try to rebuild their finances. "Investors need to be conservative in their expectations," Koesterich wrote in a recent blog post. "With the consumer still struggling, it will be hard for GDP growth to accelerate much beyond the 2 percent rate that has defined the recovery since 2009." Maybe 2014 will be better.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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