Image: Uncle Sam with an IOU © Peter Gridley, Getty Images

After years of avoiding tough choices on the debt and the deficit, a reckoning is upon us. The outlook is bad, but there is a glimmer of hope.

With a time bomb ticking, America seems to face a terrible choice: fiscal austerity and recession, or denial mixed with more debt and a new credit downgrade.  A decision must be made soon; we will reach the "fiscal cliff" on Jan. 1, and the nation will hit the $16.4 trillion debt ceiling limit in January or February.

But all is not lost. In fact, a true solution is possible. I'll outline it below and then offer some initial advice to investors.

Politicians, you've been warned

Time is running out.

Yet as deadlines approach, the leaders we've tasked with finding a solution are engaged in a political blood feud and can agree on little, if anything.

They've bungled their responses to the smaller, incremental events that helped get us here, including past battles over the debt ceiling, extending the Bush tax cuts and lengthening unemployment benefits, as well as the failure of the congressional deficit supercommittee.

Now, tougher choices are stacked up just ahead, like piles of dynamite, awaiting the election, the lame-duck session of Congress and, potentially, a lame-duck president.

Anthony Mirhaydari

Anthony Mirhaydari

The credit-rating agencies are not pleased. Fitch warns that the fiscal outlook is "mired in uncertainty" and that indecision threatens America's rating. Standard & Poor's cut our AAA rating in August 2011, to great financial turmoil and economic damage, in large part because of the dysfunction surrounding that summer's battle over the debt ceiling.

S&P has promised to take additional action unless the country starts making real, structural progress on its debt and deficit problems and addresses the "recent decline in the effectiveness, stability, and predictability of its policymaking and political institutions, particularly regarding the direction of fiscal policy."

Business leaders are not pleased. CEO confidence and plans for capital spending are way down. The August report on durable goods orders -- machinery and equipment -- dropped at a rate not seem since the depths of the financial crisis. Hiring plans are down. Factory activity is down. New orders in the Federal Reserve's regional activity surveys are down.

A Merrill Lynch survey of chief financial officers found that the "effectiveness of U.S. government leaders" is their No. 1 concern right now. In July, a U.S. Chamber of Commerce survey of small businesses found that 65% were "very concerned" about the cliff. It's no surprise that job growth, based on the payroll report rather than the volatile household survey, has stalled or that a large portion of the jobs being created are part time.

And increasingly, investors are not pleased. A Merrill Lynch survey of U.S. fund managers shows the cliff at the top of their list of concerns, as issues such as the eurozone debt crisis, Iranian-Israeli saber-rattling and the Chinese housing market fade. The fiscal cliff is also the top concern of currency and credit traders, as well as European fund managers.

In other words, even with Spain on the brink of a bailout and Greece desperate for another injection of German cash, managers in Madrid and Athens are increasingly looking to Washington -- with a sinking feeling in their stomachs.

Falling off the cliff

Europeans are all too familiar with the risks.

If Congress and the White House take no action, the cliff will result in a fiscal body blow totaling $720 billion, which is worth nearly 5% of gross domestic product. (The numbers, and some options laid out by Merrill Lynch experts, are shown in the chart below.) This includes a $120 billion hit as the payroll tax cuts -- which started in 2009 as the Making Work Pay tax credit -- expire; $110 billion in budget cuts known as "sequestration" tied to the supercommittee's failure, which will hit the Pentagon hard; and $200 billion in tax increases as the Bush tax cuts expire and Obamacare taxes on the wealthy kick in.  

However you add it up -- Merrill outlined three options -- this is a serious economic hit.

Fiscal cliff

With the economy now managing to grow at only a 1.3% annual pace -- despite massive and repeated doses of cheap-money, dollar-weakening, inflation-priming stimulus from the Fed -- you don't have to be an economist to realize this would raise the threat of recession and start unwinding hard-won progress in the job and housing markets.  

If you add in the additional drags from financial market turmoil (remember last summer's market dump related to the S&P credit downgrade?) and lost business and consumer confidence, it's an ugly outlook.

Oh, and it gets worse.

You see, we're not alone in facing this fiscal reckoning. France, Italy, the United Kingdom and Spain are all expected to tighten their budgets by 1% of GDP or more next year as the sun sets on the era of unmitigated borrowing and spending by governments. Germany, Canada and Japan are also tightening their belts.  This is the kind of globally synchronized, demand-destroying policy tightening the made the Great Depression so terrible.

Overall, the International Monetary Fund expects the advanced economies to continue such policies through at least 2015.