While households and the financial sector have made progress in rebuilding their balance sheets, they are far from healthy. Households are still battling stagnant wages and the rising cost of living. Banks are facing the loss of unlimited FDIC deposit coverage, pitiful loan demand, unattractive credit risks, falling net-interest margins, market volatility and growing calls for mortgage-principal forgiveness and other measures.

The government has stepped into the breach with cheap mortgage loans and unemployment benefits, among other efforts. If it pulls up stakes now, and starts a harsh, European-style austerity program, nearly the entire economy will be deleveraging at once. Debt reduction, not profit maximization, will become the maxim. Such is the stuff of economic nightmares and the Great Depression.

The other part of the deficit problem is "structural" and deals with the fact that areas of the economy funded by the government -- Medicare, public education and civil-service jobs -- have been insulated from the deflationary forces that have pinched the rest of the economy, especially construction (the housing bust) and manufacturing (globalization). The free market hasn't been able to control costs and demand higher quality.

The results include health care cost inflation that's been running at 154% of the overall inflation rate since 1995; mediocre health care results compared with those of other developed countries; subpar global education rankings; and state and local governments struggling to balance budgets burdened with pension and pay schemes that are far more generous than those in the private sector.

At the federal level, it's all about health care costs and the underfunded entitlement programs tasked with paying those bills. And all the while, we're neglecting to invest in infrastructure and technology that could reaccelerate the economy's growth and lessen the future burden of today's debts.

How to break the cycle

There are only a few ways out of this:

One involves a long, painful European-style repayment plan based on austerity and mixed with higher inflation from the Federal Reserve that will continue to pinch the middle class and will likely result in increased social and political turmoil -- the subject of one of my recent columns.

Or there's the "Chicago Plan" that would return the power to expand the money supply to the government (currently granted to the banks by the Fed), using the proceeds to pay down the debt. This was also the subject of a recent column.

Or there's the one-time wealth tax idea floated by Boston Consulting Group, which would tap the rich to reduce the economy's indebtedness. I discussed that plan in a column here.

And of course, the country could simply default as Greece, the birthplace of democracy, has done, succumbing to the dangers Plato warned of thousands of years ago: A government ruled by the people will, eventually, overspend and undertax to the point that its very existence and sovereign freedoms are threatened.

Right now, Athens has become a ward of its creditors, mainly the Germans. For us, will it be the Chinese?

Last year, after our credit downgrade, China's state-run media demanded that the U.S. end its "addiction to debts" and realize the "painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone" before questioning the strength of the dollar. China's Dagong credit rating agency also downgraded its U.S credit rating to A from A+, below the likes of the Czech Republic, Qatar and France. (It rates China AAA, by the way.)

Last week, Dagong put the U.S. rating on its negative watch list in response to Washington's internal strife, the risk of recession this year and a poor long-term outlook, which jeopardizes our ability to repay what we owe. There is a real risk the rating will slide to BBB+, the same as Peru, Morocco and Colombia, as the debt keeps climbing.

This dark outlook justifies my expectation of a new recession and a new bear market in 2013. The task required, a delicate balancing act between medium-term structural reforms and short-term stimulus, seems too difficult and politically challenging for our current government. We probably won't see meaningful progress until the financial market turmoil and economic spasms that lie ahead end the political gridlock in Washington after the 2014 midterm elections.

For now, I continue to recommend that investors play it defensively with exposure to the dollar, U.S. Treasury bonds and targeted short positions. Options include the iShares Barclays 20+ Year Treasury (TLT) and PowerShares DBUS Dollar Bullish (UUP) exchange-traded funds.

Risk-takers might consider adding long volatility exposure since the CBOE Market Volatility Index ($VIX) posted a historic collapse in the wake of the fiscal cliff deal. The "fear gauge" is poised for a rebound and can be played via the iPath S&P 500 VIX Short-Term Futures (VXX) exchange-traded note or the leveragedVelocityShares Daily 2x VIX Short-Term (TVIX) ETN.

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At the time of publication, Anthony Mirhaydari did not own or control shares of any fund mentioned in the column. Anthony has recommended iShares Barclays 20+ Year Treasury ETF, PowerShares DB US Dollar Bullish ETF, iPath S&P 500 VIX Short-Term FuturesETN andVelocityShares Daily 2x VIX Short-Term ETN to his money-management clients, and VelocityShares Daily 2x VIX Short-Term ETN is a member of his Edge Letter Sample Portfolio.

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.