WE’VE ALL HEARD THE WORDS.
At some point in our youth we all have been in the familiar scenario, trying to convince our parents that letting us do something stupid – go to a party or on a trip, get a tattoo, etc. – would actually be a good idea. Our logic was likely that “everyone” (translation: one friend whose parents were “cool”) – was doing it. Then we would get the timeless retort to which there is no response, “If your friends were jumping off of a cliff, would you follow them?”

Now we are the adults. Our friends in Greece, Spain, Italy, and France – you know, all those cool countries that “really know how to live” – have already jumped off of cliffs or will do so soon, and evidently the answer to that age-old question is actually, “Yes.” Yes, Mom and Dad, if all of our friends jump off the cliff, then we will, too.

On January 1, 2013, the United States of America, the great world power with the largest and most sophisticated economy on the planet, is going to be driven over the aptly named fiscal cliff. We have suffered through the worst economic recovery in our history, we are now in a new downturn and we will be facing the largest tax increase in American history with a simultaneous slashing of the federal government’s budget. Even the hyperoptimistic Congressional Budget Office (CBO) says that if something is not done to fix it, the U.S. will experience a recession in 2013. Yet this looming cliff barely garners a mention on the campaign trail.

One of the reasons it is hardly mentioned is that few really believe that our politicians are so reckless that they would actually let us fall off the cliff. The conventional wisdom is that after the election the two parties will sit down and fix this before year-end. I hope that is correct and it probably is, but that still leaves us sitting here in October 2012 with no real clue about what our tax code or government programs will look like in 2013. This isn’t supposed to happen in America, or in any developed country for that matter. This is the kind of thing that happens in “Banana Republics,” smaller former Soviet republics, and Middle Eastern dictatorships. This should be the great scandal of our time.

This whole situation was set up when the administration and Congress could not agree on a lasting fix to the debt ceiling debate in the summer of 2011. That embarrassing episode led to Standard and Poor’s downgrading our credit rating and forced our politicians in Washington to punt the decision until after the election. It is dangerous to bring up economic subjects like this, because it ultimately gets political. To avoid that trap let’s pay attention to the old adage, “Great minds discuss ideas, average minds discuss events, and small minds discuss people.” The famous investigative reporter and author Bob Woodward has published a book about the events and the cable news networks have already villainized all the people involved, so we will take the high road and discuss the ideas of what this means to us as investors and how we as a country might get out of it.

To some degree the fiscal cliff is the perfect representation of what has gone wrong in this anemic economic recovery. It represents uncertainty. The numberone concern of business leaders today is a lack of confidence and uncertainty about the future. This argument has been made many times. Some refute it, arguing that life is always uncertain. Business, economics, and investing are by their nature uncertain. Investors and business leaders always make decisions today not really knowing what will happen tomorrow. This is true, but it misses the point.

Let me use a recent analogy. Football is an uncertain game, as are all games. There is always a favorite going into a game. We know the coaches and the players, we know their tendencies. We may think we know what will happen, but as the old football saying goes, “There is a reason they play the game.” You see, upsets happen. Underdogs surprise us and stars disappoint, that is what makes us watch. We enjoy that uncertainty. It is exciting, in the same way business leaders enjoy the marketing game and professional investors enjoy the action of the market. This is the normal uncertainty in which business gets done and economies grow.

When fans pile into stadiums or turn on their televisions they may not know who will win the game, but they do know the rules. The rules are not uncertain. They are known ahead of time and there is an expectation that the rules will be enforced evenly and fairly by professional referees. When the National Football League (NFL) recently fielded replacement referees, it was a disaster. All of a sudden it was not just the game that became uncertain, but the enforcement of the rules. Ultimately it cost at least one team a game, and one game in the NFL can make the difference between making the playoffs and potentially winning the Super Bowl and not making the playoffs and watching the Super Bowl at home with the rest of America.

Similarly, the uncertainty businesses and investors face today is not regarding the usual uncertainty about the outcome of certain decisions; the uncertainty is about the rules themselves. Embarrassingly bad calls are not supposed to happen in the world’s premier football league, just as not knowing what government will do two months from now is not supposed to happen in the world’s premier democracy. It is an embarrassment, and the result is that economic activity has seemingly ground to a halt.

Of the approximately 30 companies in the S&P that have changed their earnings guidance before the release of third quarter results, 28 have lowered their estimates. A few have lowered guidance more than once. Our fear is that the third quarter results will be very ugly and we are remaining defensively positioned because of this.

We will get beyond this, and just like the NFL finally had to deal with their referees, the U.S. will have to deal with the fiscal cliff. One of our political parties suggests that we can get there by raising taxes on the wealthy. That would be laughable if they were not so serious. It won’t work for multiple reasons but mainly it won’t work because it ignores the problem. Think about your own experiences: we all know someone, a child, sibling, friend or spouse, who simply can’t seem to control their spending. We know it doesn’t matter how much money they are given, they will always find ways to spend more than they have. More income may ultimately be needed, but you must first get spending under control. You can start with small items, cut out the lunches and the Starbucks, but when the situation is severe you then must address the big items. A smaller house, a less expensive car, fewer trips, etc. Likewise, our government is no different than our friends; it has a spending problem, and it must deal with it. Its problem is severe and we are going to have to look at the big items. Social Security and Medicare must be reformed or they will drive us over the cliff just as they have our friends in Greece, Spain, Italy, and soon France.

We have another political party that refuses to raise revenues at all. This is also unrealistic. While spending does need to be controlled that cannot solve the entire problem. Just as we would advise an individual with a budgeting problem, you get spending under control first and then look for ways to increase income. The second part cannot be avoided. There are smart ways to increase revenue to government and not-so-smart ways. The not-so-smart way would be to raise income tax rates on a few rich guys.

Let me explain why this is not smart. It is just math: there isn’t enough money there. We could raise marginal rates to 100 percent on incomes over $1 million and, assuming no one changed their behavior, the money still would not make a significant dent in our debt. People talk about the evil one percent, but to be in that notorious group takes a combined household income of approximately $400,000. Those making more than $1 million are a fraction of a percent of all Americans. The idea that there are millions of billionaires out there that can pay for government for the rest of us is a fantasy. On top of that, in the real world taxes do cause changes in behavior. France just raised its top tax rate to 75 percent. Practically the next day, Bernard Arnault, the wealthiest man in France, applied for Belgian citizenship. Another example closer to home: I live 0.5 miles from my office. Over the last several months my commute has doubled as I have had to detour around multiple movie sets to get home. Why are they filming movies in Atlanta and not Hollywood? Rich people and rich industries have choices, and if one location offers a better tax environment than another they will exercise those choices.

Even if that were not the case and a government could get all it needed from the very rich, there is a danger in having a tax code that is too progressive. It does become an inhibiter of growth, but not for the reasons usually mentioned. Economic growth does not trickle down from the rich. Economic growth happens when a man like Steve Jobs starts a business in a garage. He starts it in a garage because he can’t afford to start it anywhere else. You see, Steve Jobs was not rich when he started Apple, but Apple made him rich, and that is economic growth. Growth occurs when people who are not rich today build something real that makes them rich tomorrow, along with their partners and the hundreds and eventually thousands who get jobs, hopefully with stock options, in the companies they create. When tax rates rise with incomes it does not hurt those who are already on top – they can afford it; it hurts those who are not on top today but wish to be there tomorrow. It puts a barrier in their way, and those are the people who make our economy work.

The smart way to raise revenue is to reform the tax code. Lower rates and eliminate tax breaks that are overwhelmingly skewed to the wealthy. The lower rates create less friction for the entrepreneurs who actually create economic growth, while the closing of loopholes means higher actual taxes for those who are already rich. This is how Ronald Reagan and Tip O’Neal did it in 1986, it is the basic framework of the bi-partisan Simpson Boyles plan, and it is the basic framework that just about every expert who isn’t running for office supports. Reform, however, must be designed to raise revenue if we are going to be serious about fixing our fiscal mess.

Are we going to go over the cliff? Everyone else is doing it, but we have never been everyone else. From our birth as a nation we have been a leader; a trend setter; as Reagan put it, “a shining city upon the hill.” The single biggest obstacle to American growth and future investing success is that fiscal cliff and the continued uncertainty that it represents. We need a president who is prepared to make the tough decisions to get spending under control, reform our social safety net and give us a fair tax system that reasonable people can support. As with most things in life knowing what needs to be done is rather simple, but doing it will be hard. But then, that is why they call it the highest office in the land.

Charles E. Osborne, CFA, Managing Director