Politicians in Washington and on Capitol Hill are Distracted from the Real Problem (AP)

The fiscal cliff is a less a crisis than a creation that diverts the attention of policymakers, the media and the public away from the big picture abyss that threatens the United States and shifts focus to the smaller and more immediate tax and spending debate associated with the year-end expiration of the Bush tax cuts.

The central problem facing the U.S. that few understand is the growing systemic risk from the unsustainable trajectory of deficit spending and debt accumulation and the $225 trillion derivatives exposure largely held by a handful of U.S. banks that are too big to fail.

We are told that if Congress and the president cannot agree on a bill to cut spending and raise taxes, we go over the fiscal cliff on January 1^st, which triggers the expiration of the Bush tax cuts and the sequestering of government spending by $1.3 trillion over ten years, which is about $125 billion per year or 3% of the annual federal budget. So in reality, we go over the fiscal cliff either way.  The concern is that with the latter course of reversion to the pre-Bush tax regime, the severity and breadth of the tax hikes on the middle class combined with spending cuts would be a double–barrel dose of austerity that could trigger a recession.

But what is striking about the current debate is how relatively small the numbers are compared to those associated with the greater problems of systemic risk that could precipitate a financial collapse:

• The U.S. Government bond market bubble that has grown 55% to $16.38 trillion in the first 4 years of the Obama administration, a sum which is now 107% of U.S. GDP and equals the entire debt accumulated in the first 225 years of America’s history.
•  The $220 trillion in U.S. derivatives exposure held by JP Morgan, Bank of America, Citibank and Goldman Sachs, a sum which amounts to 3.3 times the entire world Gross Domestic Product.

The fact that the Federal Reserve recently decided to more than double its monetary stimulus (also known as “money printing,” debt monetization, quantitative easing or simply QE) to $85 billion a month is telling.  It suggests the Fed may be taking emergency measures to contain systemic risk and fund deficit spending and U.S. government debt issuance foreigners no longer want. The doubling of QE to a trillion dollars a year is a complete departure from what any previous Federal Reserve board would consider appropriate or responsible.

In addition, if the Fed policy of reducing federal funds rate to zero has been unprecedented, consider the fact that we are now 5 years into this zero interest rate engineering—a Fed policy that explicitly deprives savers, especially the retired and elderly, of interest income, forcing them to spend principle or take more risk at time when they can least afford it.

Since the November 6 elections, no one seems to be discussing what the U.S. needs to do to restore its economic health and return to normal. Staying in denial and addicted to deficit spending, QE and artificially low interest rates is an unquestionably risky path—one that leads to misallocation of resources and discourages investment, capital formation and wealth creation.

Obviously QE and low interest rates  facilitate the Federal government’s deficit spending, as well as assisting in bailing out the banking and housing sectors.  But the money that the Fed is creating is making the holders of dollars nervous. If investors shun the dollar and the exchange rate falls, interest rates will rise and the price of bonds and mortgage-backed securities declines. And when debt prices fall the collateral backing the banks massive derivatives bets could trigger a financial collapse that would make 2008 look like a cakewalk.

Deficit spending financed by the printing of money and escalating federal debt cannot be sustained.  It risks triggering significantly higher inflation or a collapse of the dollar and the bond market. Either outcome hurts most the very people the Democratic Party claim to represent—the middle and lower class. Moreover, uncontrolled public debt now threatens to rupture society as the older generations’ benefits are increasingly financed by debt born by the young.

What is vital now is leadership and conviction to do the right thing for all Americans. We will get through the fiscal cliff one way or another, but then the real work needs to commence. Outside Washington, there is a palpable sense that the U.S. economy is rigged and in a precarious state. It’s time for Paul Ryan to come out of the shadows and help lead the Republican majority in the House to exercise the courage and commitment to educate the public about the nation’s fiscal reality and explain why entitlement reform and spending cuts are the essential corrective options needed to steer the nation clear of the abyss of financial collapse.

Scott Powell is a senior fellow at the Discovery Institute in Seattle. Email him at scottp@discovery.org