Image: Anthony Mirhaydari

Anthony Mirhaydari

For all the well-paid analysts and sophisticated computer systems that dominate trading, Wall Street still can't seem to focus on more than one thing at a time.

For now, the focus has returned to the European debt crisis, as the issues that cut down Greece, Portugal and Ireland have hit Spain hard.

But very soon, as Election Day approaches, the attention will turn back to U.S. debt and deficit issues, which, as in Spain, are caused by too much debt and a government trying to avoid its budget-cutting duties. Remember last summer's debt-ceiling debacle and the market meltdown caused partly by the loss of the Treasury's AAA credit rating? Get ready for the sequel.

This time, however, Washington will have to contend not only with its new $16.4 trillion debt ceiling, but with the expiration of a long list of revenue measures (Bush tax cuts, payroll tax holiday and more) and automatic spending cuts that add up to a drag on growth of around 4% of the gross domestic product.

And unless something is done, it would all happen at once -- risking a new recession outright, since the International Monetary Fund is looking for the U.S. economy to expand by only 2.1% this year and 2.4% in 2013.

This is the "fiscal cliff" Federal Reserve Chairman Ben Bernanke has been warning about. It's real. It's coming. And soon, it will be all that Wall Street's chatterboxes are talking about.

No more can-kicking

The problem is that we can no longer avoid the hard fiscal choices we've been avoiding -- a topic I've written about frequently.

We needed meaningful stimulus to boost short-term growth and slash the "cyclical" portion of the deficit related to our mediocre recovery. Not only would more vigorous growth cut the deficit by increasing tax revenues and cutting expenditures on things like food stamps, Medicaid and unemployment benefits, it would also clear the way to address the deeper "structural" deficit.

This is the real crux of the problem. And there are no easy answers. What do we do about out-of-control health care costs? Or a bloated Pentagon budget? Or a share of tax revenue, as a percentage of GDP, that has returned to levels not seen in 60 years?

The problem is worsened by demographics. More older Americans and fewer young workers to support them will put additional strain on the federal budget. Any increase in interest rates if the Federal Reserve loses control of inflation will compound the problem via higher payments on existing debt. It's an untenable position.

The White House and Congress have had their chance over the last few years to thread this policy needle, mixing short-term stimulus with medium-term austerity and essential reforms. Instead, political bloodlust killed any chance of mindful bipartisanship. The recommendations of the Simpson-Bowles deficit commission were ignored, and the Congressional Joint Select Committee on Deficit Reduction -- the "supercommittee" -- simply failed to produce results.

A big part of the reason analysts at Standard & Poor's pulled our AAA rating back in August was our dysfunctional politics. Democrats and Republicans didn't address the issues. And they didn't merely kick the can down the road -- they held all of us hostage to 11th-hour brinkmanship as the debt ceiling approached to score points with far-left and the far-right extremists.

You see, after years of fiscal irresponsibility, we face an inescapable dilemma: We fly off the fiscal cliff, cutting the deficit by crushing the economy and, like Europe now, repeating the mistakes of the 1937 Great Depression double-dip; or we swerve, keep our tax cuts and benefits but watch in horror as a lingering deficit doubles the national debt over the next 10 years.

Economic research suggests both higher debt and deep short-term austerity limit economic growth. So we can pick our poison. You want the hurt now or later?

Total federal government debt © MSN Money

What's worse is that the choice must be made with a gun to the head. The chart above shows that we're fast approaching the new, raised debt ceiling.

A decision on all of these issues -- the deficit, the debt ceiling, tax cuts and unemployment benefits -- will need to be made in the context of a fierce, polarized presidential election, the lame-duck congressional session that will follow and an even-more-divided government in 2013. Prediction markets suggest President Barack Obama will win re-election and Republicans will hold the House and retake the Senate.

A rudderless ship of state

Here we are, barreling toward the edge, and the two parties are pulling in opposite directions. The two camps couldn't be more divided.

In March, Republicans in the House passed their 2013 budget proposal, dubbed "The Path to Prosperity," combining tax cuts with dramatically lower spending. In it, the free-for-all smorgasbord that is now Medicare would end in 2022 for those born after 1956, to be replaced by a private-insurance-premium-support system. Seniors would be on the hook for the difference between the government vouchers and their insurance premiums.

Other government spending, save Social Security and defense, would also be slashed.

Obama, for his part, unveiled a more middle-of-the-road budget featuring new taxes on those making more than $250,000 a year, extension of payroll tax cuts and unemployment benefits, and cuts in areas such as agricultural subsidies and health care payments.

The contrasts are stark. The Republicans would cut the public debt to 10% of GDP by 2050. Current law, the fiscal cliff, would cut the debt to 42% of GDP. Obama's plan would see debt increase to 124% of GDP. And, the Congressional Budget Office's "alternative fiscal scenario" -- which would see expiring tax cuts extended, Medicare payments to doctors held steady and Bush tax cuts kept -- would put the debt at more than 200% of GDP. I'll dub this the KTC option, for kick the can.

Even the KTC option could be considered overly optimistic.

It assumes that the economy revs up and returns to full employment by 2015 and stays there. In other words, KTC assumes the new recession in Europe and the "hard landing" in China don't translate into a slowdown here. In fact, it assumes no recession through 2022. Given the issues we face -- higher inflation, crimped consumers and a poor job market -- this isn't realistic.

Lower debt is good, obviously -- but not at the expense of growth. The Europeans are beginning to realize this, which explains why Madrid and Rome are beginning to chafe at budget austerity demands out of Berlin. Indeed, Italy announced Tuesday that it will delay by a year its current plan to balance its budget in 2013 as the eurozone tips into a new recession.

Image: Fiscal drag © MSN Money

As a rule of thumb, each percentage point of deficit reduction takes a percentage point off of GDP growth. So the Republican plan would cut growth by 2.6% next year and 2% in 2014; the fiscal cliff would take 3.7% off next year and 1.5% in 2014; Obama would see 1.9% taken off this year and next; and the KTC option would see 1.4% taken off next year and 0.5% in 2014.

Compare that with the near-5% tail wind we enjoyed in 2009 as the stimulus kicked in and stocks rocketed higher.

Entitlement spending is the problem. According to Credit Suisse, spending on Social Security and health care programs will amount to nearly 13% of GDP in 2022 versus an average of 7.3% between 1972 and 2011. All other spending will fall to 7.8% from 11.4%.

My solution is to take the Republicans' desire to insulate the Treasury from incipient health care cost inflation while, mindful of the lessons of the 1937 double-dip and the eurozone's current woes, adopt the Democrats' desire for short-term economic stimulus on things like infrastructure and research-and-development credits.

But I'm not holding my breath that consensus can be found without another confidence-sapping, market-shaking showdown. That would likely encourage Fitch and Moody's to follow S&P's example by calling out the obvious: America just isn't the credit risk it used to be as the elephants and donkeys in Washington bicker, posture and bloviate all while coddling the most important voting bloc of all, senior citizens.

Last November, I warned that the dynamics of democracy will likely prevent any meaningful progress on the structural deficit without a bond market revolt. I think it's worth repeating:

"In the months to come, if the two parties battle as the economy burns, the solution embraced in Italy and Greece -- unelected technocrats -- may look more and more attractive as the deus ex machina to get us out of this mess.

"Greek philosopher Plato warned of this more than 2,400 years ago in ancient Athens, claiming that the absolute freedom of democracy and the freedom of speech and license to do as one wishes can devolve into an unmanageable state. He compares such a place to a dilettante with no discipline; a hedonist with neither order nor necessity nor an appetite for sacrifice and self-control.

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"The country, drunk on the insatiable desire to have no master in any facet of life, becomes intolerant of any whiff of elitism, fiscal responsibility or denial of any earthly desire. Leaders aren't allowed to place the least bit of austerity on their people. To stay in power, they must be pliable and provide plenty of what the people want -- namely, low taxes and lots of government spending.

"Otherwise, they are punished. Think about that when the 2012 elections roll around."

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.