A wake-up call

We're in a quandary generations in the making; it can't be boiled down into simple talking points. The electorate just doesn't get it -- with polling suggesting the only solution that garners majority support is taxing the rich. That would help, but it's not enough -- not even close.

(Letting the Bush tax cuts on those making more than $250,000 a year expire will raise around $50 billion to $80 billion a year. Obama is now calling for even more revenue, about $120 billion a year in new taxes. Those numbers pale next to the impact of the fiscal cliff, which Merrill Lynch puts at $720 billion for next year.)

Part of the deficit is a result of a weak economy. Part of it is there because the middle class is still under pressure with joblessness, stagnant wages and negative home equity. Part of it is a consequence of accumulating too much debt because of Bush-era mismanagement, two wars, the 2008 financial crisis and an overreliance on cheap foreign credit from China and Saudi Arabia.

But most of it -- especially the projected deficit over the horizon -- is there because the health care system grew, like a metastasized cancer, into a fat, inefficient resource sink that's not delivering benefits on par with what we're paying. We've decided to postpone the hard choices on what we are prepared to offer seniors who have paid into Medicare and now expect payouts that far exceed their contributions.

Medicare costs are expected to double, to $1 trillion, over the next eight years. Yet according to the Urban Institute, the average couple turning 65 in 2010 had paid $109,000 in Medicare taxes but would receive $343,000 in benefits. And that assumes contributions grew at a 2% real rate of return.

If you take one thing away from this column, burn the image below into your memory. It's taken from Obama's 2013 budget proposal -- which is very similar to his recent fiscal cliff deal proposal.

Publicly held debt under 2013 budget policy extended

Even under unrealistically optimistic economic growth assumptions, and with $150 billion a year in new taxes on the rich, his plan would see both the national debt and deficits continue to grow, due to, as he admits, a lack of meaningful entitlement reforms. (To be fair, there's no Republican plan that keeps debt from rising without gutting non-defense, non-entitlement spending.)

The problem would get much worse if the Fed lost control of inflation or if economic growth turns out to be weaker than Obama expects, which seems likely (he is looking for 3% growth in gross domestic product next year, 3.6% in 2014, 4.1% in 2015, 4% in 2016 and 3.9% in 2017).

Growth now

Moreover, one must consider why current growth is so inadequate. According to new research by the Congressional Budget Office, it's because of a lack of investment in new capital, new hires and new infrastructure. The cash is out there, floating around at nearly zero cost, thanks to the Fed.

But those who have it -- the top 2%, as well as foreign nationals and global corporations -- are scared to do anything with it.

So if we go after these folks with higher income tax rates, higher capital gains taxes and higher payroll tax rates -- in addition to Obamacare-related tax surcharges already about to hit these folks -- do you think that will change?

I know Warren Buffett -- Obama's wingman on these issues -- says those looking to invest don't consider taxation before jumping in, but that's not what economists tell us. It's all about cost of capital and rates of return. And higher taxes raise the cost of capital (especially for small businesses funding expansion and hiring out of retained earnings) while lowering future profits.

It that what we want? Less investment and hiring? The left's economist-turned-deity Lord (John Maynard) Keynes himself wrote that "the weakness of the inducement to invest has been at all times the key to the economic problem."

James Poterba, an economics professor at the Massachusetts Institute of Technology, found that higher capital gains taxes had a "significant influence" on the demand for venture funds. Nobel laureate Robert Lucas estimates that eliminating the capital gains tax and dividend taxes would spur growth and cause America's productive capital stock of plant and equipment to grow large as it is now -- increasing a productive capacity that hasn't really grown since the late 1990s.

The real risk of austerity

We risk repeating the mistakes Europe is making by forcing deep austerity measures -- both spending cuts and tax hikes -- like those now causing so much pain in Greece and Spain. Already, according to the International Monetary Fund, 22% of the current $1.1 trillion annual U.S. budget deficit is the result of a weak economy.

Unless we get the economy revved up again, this austerity-driven madness will end in disaster.

The IMF is screaming as loud as it can that a combination of tax hikes and spending cuts would be even more toxic to the economy, given the environment we're in: ultralow interest rates, indebted households and government, and persistent joblessness.

The time to tackle deficits is when the economy is strong. We didn't. And that isn't Obama's fault.

Yet attacking the rich, especially if the motivation is social fairness or outright retribution for perceived grievances (let's get those fat-cat bankers), will prove to be a tragic example of cutting off your nose to spite your face. We need to solve the root causes of the problem -- or else we're destined to a future of economic stagnation, more joblessness, less investment, higher inflation (as the Fed tries to compensate for poor fiscal policy with more monetary policy stimulus), more structural inefficiencies, higher taxes and persistent deficits.

Don't get me wrong: I am well aware that the economy has grown more unequal, and I have written frequently about it.

Over the past 30 years, the share of the economy held by labor -- working families -- has fallen due to a combination of factors. Some of these were self-inflicted, as people filled their homes with cheap Chinese imports, trading jobs for HDTVs. Some of this was related to Beijing's currency manipulation and unfair trade practices. And some was caused by a stall in U.S. labor productivity as capital investment cooled.

But austerity isn't the way to solve this. Yes, the rich have a role to play in "resetting" this morass. And I'll discuss two ways they can do that next week. So stay tuned.

Shock treatment

The threat of going off the fiscal cliff, as scary as it will be for many people, might be the slap in the face America needs to start thinking more broadly after years of fiscal cowardice. And this short, lame-duck session of Congress is a good time for big action.

Yes, thinking big means ignoring the shrill voices of rigidity -- whether it's the AARP protecting entitlements or Grover Norquist defending his anti-tax pledge. It means no more demagoguery. And it means ignoring the sirens' call to concentrate on merely soaking the rich.

For investors, things could break either way. We could go over the cliff, and stocks could follow. Or Obama and the Republicans could hammer out a short-term deal and agree to tackle entitlement reform in the New Year -- a positive outcome that would surprise pretty much everybody and send stocks screaming higher.

For now, after showing renewed optimism in November, investors seem to be pulling back. Option protection is rising in popularity on a scale not seen since the September market top as people try to insulate their portfolios from the uncertainty. And key market issues, including Goldman Sachs (GS) and Deere (DE), are looking very weak.

But the bears are constrained by next week's December Federal Reserve meeting, where the central bank is likely to announce a fourth round of quantitative easing.

If that isn't enough to make you expect a jumpy, volatile market heading into the end of the year, consider this: After the cliff comes the debt ceiling -- which we could hit as soon as February. If Washington gives us another go-round over that, we could face a repeat of the market chaos of August 2011 and the debt downgrade that resulted. 

Let's hope Washington faces up to the hard choices before that.

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At the time of publication, Anthony Mirhaydari did not own or control shares of any company mentioned in this column in his personal portfolio. He has recommended shorting Goldman Sachs to his clients.

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.