FORTUNE — President Barack Obama’s remarks on Friday should leave no doubt in anyone’s mind. While he is willing to compromise with the Republicans to prevent the United States from going over the fiscal cliff, he will NOT do so by again agreeing to extend the Bush tax cuts for the richest Americans.
We should expect him to maintain this position, even as the nation’s anxiety increases with respect to this self-inflicted problem that, if handled badly, would unambiguously push the country into another costly recession; and we should expect him to prevail.
Higher tax rates for top earners are one of the many fiscal measures that would automatically go into effect in the New Year. The projected economic impact of this fiscal cliff is a direct fiscal contraction of some 4% of GDP. There would also be negative economic and financial multiplier effects as well as inefficiencies arising from the rather blunt composition of the fiscal measures.
In combination, the consequences would be debilitating for our slow-growing economy with high unemployment and limited policy flexibility, on account of policy interest rates that are already floored at zero. And we also should not forget that the U.S. faces headwinds from the European debt crisis, a slowing China and instability in the Middle East.
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This fiscal package was purposely designed to be extremely unpleasant for the economy – even for one that needs medium-term fiscal consolidation. Indeed, it was never meant to be implemented. Instead, its nasty potential consequences were meant to scare our politicians into agreeing to a much more sensible set of fiscal reforms.
But the designers of this strategic approach failed to fully consider the extreme polarization besetting our political system. With each party lacking trust in the other, and with no credible instrument of cohesive enforcement, the threat has not worked. So America is now looking at the worrisome possibility of a recession in 2013, joblessness surging back above 9%, and the young and long-term unemployment languishing even more.
President Obama is ready to compromise on a “mini bargain” to avoid this, but only if taxes on the richest Americans are allowed to go back up – thus completing the Bush era round-trip voyage for what were meant to be temporary and reversible tax cuts for the highest earners (and that have now persisted for 12 years).
Republicans say no way. For them, any compromise must include maintaining the cuts.
We should expect this impasse to persist for a few weeks, adding to the anxiety that Americans already feel – and which has already undermined growth, investment and job creation. After lots of high drama, a compromise is likely to emerge in the eleventh hour and it will be one in which President Obama prevails.
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The President has the stronger set of arguments. He knows it. The Republicans know it. And it is only a matter of time until enough citizens realize it too.
Politically, the President just won a decisive election in which income distribution was a key issue, including the persistent relative decline in the wellbeing of middle- and low-income Americans. His national victory was supported by states such as California where, collectively, citizens directly voted for higher taxes on the rich in order to better fund education.
Americans also know that the last decade has been a particularly prosperous one for the rich. Their income and wealth rose at pronounced rates in the good years; and the downside during the bad years was curtailed for many by government bailouts and unprecedented central bank activism.
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While most Republicans will acknowledge all this, they will argue that taxing the rich is bad for all – principally because it reduces incentives for entrepreneurship, risk taking and economic expansion.
While true at higher tax rates, it is a bit of a stretch to make this an overriding argument in present circumstances and in light of recent history. It is an even more problematic argument when compared to the alternatives – of going over the fiscal cliff or avoiding it by forcing greater adjustment on those already struggling and whose marginal propensity to consume is inevitably higher.
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When push comes to shove, and it will, rationality will ultimately prevail.
President Obama will – and should – insist on increasing taxes on the highest earning brackets. The Republicans will shout and scream but end up going along. An economic debacle will thus be avoided.
America will breathe a collective sigh of relief. But it will be dampened by the realization that this is only a small battle in America’s multiyear war to restore economic dynamism, ensure financial soundness, and overcome political dysfunction. And here the need for constructive interactions between Democrats and Republicans is even more demanding, yet just as urgent and important.
Mohamed El-Erian is the CEO and co-chief investment officer of PIMCO.
