With every passing day, the risks are rising that Washington will soon create real havoc in the U.S. economy. The “fiscal cliff” set of measures that was agreed upon many months ago is now just seven short weeks away. To hear the latest press reports, Washington will kick the can down the road and throttle back this massive package of spending cuts in coming weeks.

Yet even if Washington shifts gears and avoids the fiscal cliff, there is still ample reason for concern. Simply put, big changes are coming, and they are unlikely to be helpful to the U.S. economy.

A huge brake 
Believe it or not, the stunning run of budget deficits during the past decade has actually been good for the economy. It’s simple math. The government has pumped more money into the economy than it has extracted, which has supported all kinds of sectors from defense to health care to technology to education.

We can all agree that it’s wise to eliminate our budget deficits so we don’t leave an even bigger mess to the next generation. But it’s also crucial to understand that reversing our nation’s massive debt load — which now exceeds $16 trillion — means the government must cut spending in line with tax revenue while starting to pay down the debt. It’s as if the government will put its foot on the economy’s brakes for a long time to come.

But we shouldn’t be concerned about that just yet. Right now, there is a growing understanding that long-term fiscal rectitude is a great plan, but that it’s unwise to put the $600-billion brake that the fiscal cliff would entail on the economy. This means budget deficits will likely persist at least through 2013 and 2014, meaning that $16 trillion amount of total debt might rise past the $17 trillion mark in 12-18 months. 

It’s simple to understand why the fiscal cliff is so scary. That $600-billion brake equates to roughly 3.5% of gross domestic product (GDP), which means it would reduce the economy’s growth rate down to pretty much zero. An economy growing in the projected 1.5% to 2.5% range in 2013, which now looks increasingly likely, means the 3.5% drag would push the U.S. economy into recession. Keep in mind that it only takes two consecutive quarters of negative GDP to reach a recession. And as we’re seeing in Europe, economic contraction reduces government revenue, making the goal of a balanced budget even more elusive. Still, brace yourself for some sort of deal that only creates a 1% or 2% drag on the economy. This would still create a headwind for an already-struggling economy.

If there’s a will, there’s a way
Now that we’re all sufficiently scared, let’s take a look at how we might avert such a mess…

It appears that both parties agree that automatic cuts the fiscal cliff envisions are not the right way to go. Instead, look for a bipartisan agreement that doles out less pain in 2013, in the form of modest government cutbacks and tax increases. Yet as we wend our way through 2013, it will become apparent that steady rounds of spending cutbacks and modest tax hikes will become the norm for 2014, 2015 and beyond. Look for Washington to craft a plan that methodically shrinks the deficit in perhaps half a decade.

#-ad_banner-#But here’s the rub. Any budget plan will implicitly assume the U.S. economy will grow stronger. A rising economy brings in additional tax revenue, which will underpin the math in any budget deal. But what if the economy doesn’t rebound as hoped? Then, the budget math gets trickier as the revenue side of the equation disappoints.

Even with these cross-currents to navigate, we still haven’t even talked about reducing the national debt, which can only happen when the government runs a surplus. And frankly, the only time the government can seek to do that is when the economy is quite strong, and the braking power of a surplus doesn’t keep an economy from stalling. We don’t even know when we’ll be seeing GDP growth exceed 3% or 4%.

There is a best-case scenario to ponder: If both sides agree on a credible plan that pushes the government’s books back into balance in the next half-decade, then the business community may respond positively, and step up investments and create the robust economic backdrop that is so badly needed for all of this to go smoothly. Right now, this seems like an overly-optimistic outlook, but the United States has proved to be quite resilient many times in the past. 

Risks to Consider: This analysis assumes that cooler heads will eventually prevail, but Washington has snatched defeat form the jaws of victory many times before.

Action to Take –> Inaction is not an option. Regardless of the ultimate solutions devised, we already know what investments to avoid: Any companies that do a lot of business with the government may suffer a great deal of pain in coming years as its revenue shrink.

Investors can no longer afford to ignore this issue. The process of cancelling the “fiscal cliff” program is just the first of many steps Washington will need to take as it addresses this critical problem. Track events closely to see what type of eventual compromise may take shape. In an ideal world, Congress won’t wait until the lame-duck session after the election and will take action earlier. But to paraphrase a former government official, “We’re stuck with the Congress we have, not the one that we want.”