The Fiscal Cliff and Its Effects On the Gold Market
Bullion Offers a Golden Parachute As the U.S. Teeters On the Edge of a Dangerous Precipice
The “fiscal cliff” is dominating the news right now. Federal Reserve chief Ben Bernanke coined the term to describe the potential recession-inducing scenario the U.S. is facing on Jan. 1, 2013, when the Budget Control Act of 2011 is scheduled to go into effect.
What is the fiscal cliff? It’s a more than $600 billion combination of tax increases and government spending cuts that kick in on Jan. 1, with some analysts predicting possible economic chaos as a result. The new law will end the temporary payroll tax cuts and result in a 2% tax hike for workers; rescind various tax breaks for businesses; slap more Americans with the alternative minimum tax; and allow the 2001-03 Bush tax cuts to expire. Meanwhile, tax increases stemming from President Obama’s health-care reforms will begin, as will the spending cuts agreed upon as part of the 2011 debt-ceiling deal, affecting programs from defense to Medicare. At the same time, the spending cuts agreed upon as part of the 2011 debt-ceiling deal will begin, affecting programs from defense to Medicare.
Despite all the endless speculation about what U.S. lawmakers will decide, they face some tough choices that really boil down to just three possibilities:
- They can drive the U.S. off the fiscal cliff, resulting in a severe blow to gross domestic product that will drive the economy back into a recession;
- They can cancel some or all of the scheduled tax increases and spending cuts, thereby increasing the federal deficit, potentially damaging the U.S. credit rating, and sending the U.S. closer to a debt crisis like that threatening the eurozone;
- Or (in the likeliest scenario) they can figure out a way to delay the fiscal cliff and kick the can down the road, as lawmakers so often do when facing difficult or unpopular choices. The problem is that the further down the road we go, the tougher the consequences are going to be when we ultimately decide to fix things.
Why the fiscal cliff is good for gold
First and foremost, the fiscal cliff creates economic uncertainty. We’re already seeing that: Just the anticipation of the impasse in Washington has caused many businesses to freeze hiring and cut back on investment and expansion. Since time immemorial, gold has been a top safe haven investment during times of uncertainty and fear.
Secondly, if the tax increases and spending cuts occur, the U.S. will fall back into a recession, causing the Federal Reserve and the U.S. Treasury to flood the economy with even more dollars. This monetary tide will stoke inflation and likely send gold well beyond $2,000. Two rounds of quantitative easing (QE) have expanded the monetary base by more than $2 trillion, and gold has soared to nominal record highs. The third, “unlimited” round of QE is just getting started, and a recession would force the Fed to go even further than the $40 billion a month it has pledged for QE3.
If a compromise is reached, the U.S. government will have to figure out how to pay for whatever that agreement brings. The Republicans want to decrease government spending and cut taxes, while the Democrats want to increase spending and taxes. Something has to give, but one thing is clear: There won’t be enough money to pay for everything. The debt ceiling will have to be increased, the government will have to borrow more money, and fewer and fewer investors will want to take on our debt (in the form of U.S. Treasuries).
The important thing investors can do now is protect their portfolios with gold. Just a 15% to 20% allocation will give investors the insurance they need as our nation stares down at the edge of this gaping, uncertain fiscal cliff. If our lawmakers don’t tread this tightrope carefully, investors will be glad to have invested in a golden parachute.