Understanding the Fiscal Cliff: What It Means for Your Money

Uncertainty reigns, causing anxiety for investors and jobseekers.

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Earlier this week, U.S. Federal Reserve Chairman Ben Bernanke warned that the U.S. economy was on the verge of a slowdown.

In testimony to Congress, Bernanke said "economic activity appears to have decelerated" from the first quarter, and that all "available indicators point to a still smaller gain in the second quarter." Most ominously, he admonished Congress to "do no harm," and told lawmakers that "fiscal decisions should take into account the fragility of the economy."

[See For Investors, an Uncertain Second Half.]

The decisions Bernanke was referring to are collectively called the "fiscal cliff." By the end of the year, Congress must decide whether to approve or deny a number of policies that will directly impact the economy. These policies include tax increases and spending cuts that could send the country back into recession.

Republicans are advocating for spending cuts without tax increases. Democrats are seeking to combine spending cuts with tax increases. According to the Congressional Budget Office, a compromise between the two positions—extending tax cuts while cancelling spending cuts—would allow modest economic growth to continue.

But a compromise solution seems unlikely. Washington remains politically deadlocked, and little is expected to change before the presidential election this November. Many on Wall Street now say the lack of faith in Congress to compromise has made the fiscal cliff and the uncertainty it has caused a greater threat to the U.S. economy than the European sovereign debt crisis.

"The results [of failure to compromise] are bleak but clear-cut," George Mason University Professor Stephen Fuller said in a report this week on the implications of the fiscal cliff. "The unemployment rate will climb above 9 percent, pushing the economy toward recession and reducing projected growth in 2013 by two-thirds. An already weak economy will be undercut as the paychecks of thousands of workers across the economy will be affected from teachers, nurses, construction workers to key federal employees such as border patrol and FBI agents, food inspectors and others."

The potential for economic catastrophe has created widespread uncertainty about U.S. markets, leading to steep day-to-day losses and gains. These kind of swings cause portfolio values to fluctuate wildly and can make average investors nervous.

But according to investment experts, the best move for retail investors is to stay calm and ride out the storm until after the election. For aggressive investors, there are buying opportunities available now that could pay off down the road. And for recent college graduates and people without jobs, planning ahead to make ends meet is imperative during uncertain times. As unpleasant as it might be, there is little choice but to wait things out.

[See Dividend Investors' Looming Catch-22.] 

Hope for compromise, but lack of faith in Congress persists. The most likely outcome of fiscal-cliff talks is a series of stopgap measures that would allow policies to continue in the short term without addressing the long-term debates over national debt and tax policies. The outcome of the presidential election will also play a large part in how negotiations proceed: A decisive victory for either party would greatly influence how negotiations proceed.

But there is growing concern that without a decisive victory by one party, Congress and the White House could repeat last summer's debt-ceiling brinksmanship. Last-minute compromises were made to keep the country from defaulting, but the political gridlock that precipitated the compromise caused Standard & Poor's to downgrade U.S. debt for the first time in history. 

Liz Ann Sonders, chief investment strategist at Charles Schwab, says there is a pervasive sentiment on Wall Street that Congress could cause a similar panic during fiscal-cliff talks. "There is this tiny little hope inside of me that we have adults in Washington. There's a tiny piece of me that believes something gets done," she says. "But with all of this political brinkmanship, Congress is likely to kick the can down the road with some sort of extension for several months so that the new Congress can have time to deal with it. There's very little expectation in this Congress compromising."