You don’t have to be a fan of profligate government spending (and believe me, I’m not) to recognize the enormous paradox the United States faces in getting its economic and fiscal houses in order.

In a nutshell, that paradox is this: The US economy is driven largely by consumption — roughly 70% of gross domestic product (GDP) comes from personal consumption. A large and growing percentage of that consumption is dependent on federal “transfer payments” — direct government payments to individuals (everything from Social Security to unemployment insurance). Yet as the United States tries to get its deficit under control, these payments could be cut. That in turn could have a significant impact on disposable income and economic growth.

As everyone is aware, US consumers are already facing multiple headwinds. They are still carrying too much debt, suffering from the aftermath of the bursting of the housing bubble, facing harsh credit conditions, and, most importantly, experiencing slow real wage growth. Until those headwinds dissipate, don’t expect strong economic growth to resume in the United States.

To some extent the full impact of these headwinds has been mitigated by a surge in federal transfer payments. This is not just a recent phenomenon: Over the past 50 years, transfer payments have steadily risen. But this trend has accelerated since the financial crisis hit. Today, as I’ve mentioned before, transfer payments comprise 20% of disposable income in the United States. Put differently, 20 cents of every dollar of after-tax income comes via checks from the federal government.

Not only do transfer payments make up a significant portion of disposable income, but growth in transfer payments is increasingly driving overall income growth. Since the end of 2007, more than 60% of the increase in disposable income came from increases in transfer payments.

The bottom line is this: Given the fragile state of the consumer, and weak wage growth, a near-term cut or even deceleration in transfer payments is likely to be a significant hit to disposable income — and by extension, consumption and overall GDP growth.

There are numerous ways that transfer payments could be impacted as part of the continuing budget negotiations in Washington. Some of these may be longer-term adjustments (such as changing the inflation calculation used in Social Security) that would not affect the near term; others may be immediate cuts that have more significant short-term consequences. In any case, it will be important to monitor events in Washington to gauge the economic impact of cuts.

Make no mistake: I believe the United States needs to undergo a significant fiscal consolidation. Such a consolidation would not only benefit the economy, but financial markets as well. Ideally, it would focus on the longer-term sustainability of entitlement programs, which are largely responsible for projected deficits in the coming years and decades.

In the absence of this (and I believe that Congress is unlikely to definitively address entitlement or tax reform until after the 2012 Presidential election, at the earliest) there is a risk that Congress attempts to reduce the deficit too much through immediate cuts. Regardless of the longer-term merits of this approach, to the extent that these cuts affect transfer payments they will hurt income growth at a time when the US economy is still fragile.

Under such a scenario, the United States could experience a further economic deceleration, which, given investors’ focus on economic growth, would certainly be negative for US stocks.

If we see this scenario unfold, investors could consider an overweight to international markets that are relatively insulated from US consumption. For example, Brazil (potential iShares solution: EWZ) is a country with significant domestic consumption, and therefore somewhat insulated from US-driven demand (For more on why I like Brazil, see here).

Disclosure: Author is long EWZ

Source: Bloomberg

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.