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Will the Government Decapitate the Economy on 12/31/2012

Forget December 21st, 2012 as the day of Armageddon. Wall Street has its own day of reckoning looming on the calendar.

After hearing for years the consequences of the proverbial kicking the can down the road, that day might be arriving on New Year's Eve. The partisan politics in Washington has created a potent fiscal cocktail that could leave the markets with an economic hangover like it has never felt.

On December 31st, a series of key policies come to a head:

1) the expiration of all Bush Tax Cuts;

2) we'll probably need to raise the Debt Limit; and

3) the expiration of payroll tax cuts.

And if those three events weren't enough, on the very next day, the defense sequestration cuts are set to kick in.

“It’s one of the biggest of convergences of events from a budget and economic point of view in the history of the country,” said Roger Altman, former Deputy Treasury Secretary and Founder and Chairman of Evercore Partners. “But the timing could be an opportunity for tax reform. With all of the Bush Tax Cuts expiring, the President has a chance to really make substantial reform.”

The raw wounds of uncertainty and the economic paralysis the debt ceiling battle caused last August are still fresh in the memory of some economists like Diane Swonk, Chief Economist at Mesirow Financial.

"One would have hoped we learned something and at least use the lame duck session to make some substantive decisions on the course of fiscal policy. Even if that is achieved it will likely be too late to not create some sort of a speed bump in the fourth quarter,” Swonk said.

To show the impact of policy uncertainty, Steve Davis, professor of international business and economics at the University of Chicago Graduate School of Business, created the economic policy uncertainty index (www.economicpolicyuncertainty.com). The trend shows since 2008, the level of uncertainty has doubled the level of the previous 23 years.

“Unless Washington ends its increasing reliance on ‘temporary’ spending and tax policies, it will just keep fighting last year’s battles, engendering financial uncertainty for job creators, failing to address our most serious challenges, and perpetuating economic policy paralysis,” explained Charles Blahous, Mercatus Center senior scholar and Public Trustee for Medicare and Social Security.”

Mark Zandi, chief economist of Moody’s Analytics, stresses the fiscal headwinds set to hit at the start of next year under the current law are very formidable and a significant worry.

“If policymakers can't come to terms in a reasonably graceful way and make some changes to tax policy in particular the economy will slow sharply in early 2013. What changes are made will depend significantly on the results of the election,” Zandi said.

Defense industry insiders say the timing of these decisions could not be worse since the consequences of such inaction will be felt when the $54.7 billion dollar cuts from the defense sequestration begins.

“This is not a haircut—it’s a decapitation that some say will permanently add to the under employed and unemployment rate," warns Marion Blakey president and chief executive officer of the Aerospace Industries Association. "The human calamity as a result of these job losses will be very severe. When people talk about the defense budget as part of the solution we understand that. There have been significant cuts already made. There is no fat. We are way into muscle and tissue and we are now getting into bone."

So as the country braces for a series of expected continuing resolutions to run the country and the temporary extensions of the payroll tax cuts, Wall Street will have to wait to see if leadership will rise and the President and Congress put their differences aside, roll up their sleeves and get to work. But if recent history is any guide, it’s more likely our holiday cocktail will include an extra-potent serving of uncertainty in an already potent mix.

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Lori Ann LaRocca is a Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."

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