May 3, 2012

Mohamed A. El-Erian is chief executive and co-chief investment officer of the investment management firm Pimco and author of “When Markets Collide.”

Economists are rightly starting to warn that the United States faces a worrisome “fiscal cliff” at year’s end. The blunt spending cuts mandated by the 2011 compromise on the debt ceiling — and the failure of the “supercommittee” that followed — along with across-the-board tax increases would derail the U.S. recovery and undermine the well-being of the global economy. We should be avoiding the edge of this cliff — and politicians should not believe that they have until the end of this year to act.

In the next few months, possibly within weeks, markets here and abroad will be looking for signals that our politicians understand the severity of the situation and are able and willing to act appropriately. If clear signals are not forthcoming, markets could react early to the looming trouble, compounding the uncertainties that weigh on the U.S. economy.

It is well known that both Democrats and Republicans in Congress have failed in the past few years to address our nation’s difficult fiscal issues. The most visible example is the repeated absence of a comprehensive annual budget. Less obvious but equally important is the large and meaningful collection of budgetary reforms that have been delayed, obfuscated and derailed. In the process, all sorts of spending cuts and tax increases got kicked further down the road. Now, a meaningful and consequential set is coming together in a rather disorderly fashion.

The sequestration mandated by the Budget Control Act of 2011 and the reversal of the Bush-era and payroll tax cuts would essentially mean withdrawing from the economy some 4 percent of the national income in one blunt go — and this doesn’t factor in possible knock-on effects. The importance of this issue cannot be overstated. A fiscal contraction of this magnitude and composition would stop dead in its tracks the economy’s nascent healing and job creation. Consumption and investment would be harmed. Foreigners would become more cautious about buying our ever-increasing debt issuance. And with our internal growth momentum weakened, the headwinds from the European debt crisis could prove overwhelming.

As opposed to such a disorderly big bang, the U.S. fiscal situation requires a carefully designed and well-timed overhaul to make government finances more efficient and fairer — among other things, combining immediate stimulus with a credible set of medium-term tax and entitlement reforms and a sustainable effort to reduce the deficit over time. But rather than addressing our fiscal challenges with a scalpel, America is reaching for a blunt ax that is likely to do more harm than good. Indeed, several items set for implementation at the end of 2012 would impede further economic growth, job creation and medium-term financial stability. Some measures — including cuts to education programs and teaching jobs when our educational system is already under tremendous pressure — would go even further, causing inconsistencies between spending priorities and, in some cases, creating pockets of operational paralysis.

The worries do not stop here. Never mind that it has been less than a year since the last political circus over the debt ceiling caused an economic slowdown, fueled concerns about a double-dip recession and contributed to Standard & Poor’s downgrading the United States’ sacred triple-A credit rating. Just as few in Washington presumed last year that things would reach that point, few think the fiscal cliff will materialize. After all, the deadline was always meant to act as a catalyst for serious revenue and expenditure reforms — including revamping the federal tax code, streamlining entitlements and realigning incentives to favor production and investment rather than consumption and operational avoidance of U.S. tax jurisdictions. But complacency has continued to reign, leaving the country exposed to unnecessary economic trauma and renewed political dysfunction.

Markets are discounters of the future, and prolonged political inaction is likely to encourage companies to postpone building plants and purchasing equipment and to discourage them from hiring.

All this speaks to the importance of acting now to avoid getting too close to the cliff’s edge. The good news is that quite a bit of technical work has been done in Washington on proper fiscal reform, along with background scenario analyses. Also, I suspect that, in their hearts, most politicians from both sides of the aisle recognize that progress necessitates a series of confidence-building compromises that are in the nation’s interest.

But I fear that, once again, we are more likely to witness dithering and bickering in Washington, accompanied by political posturing packaged in competing election-driven narratives. If these concerns materialize, and I sure hope they don’t, the economy will slow during the summer, rating agencies will again get nervous and the political environment will become even more polarized.

It is unfortunately once again time to fasten your economic seat belts.