At last Washington has reached a deal that raises the debt limit and averts a default that would have been a national embarrassment and an economic and geopolitical catastrophe. The forces shaping the deal and the deal itself are multifaceted and so also is the right reaction to it. Mine has a number of elements.
The first is relief. There will be no first default in US history; no economy-damaging short-run austerity; no attack on the nation’s core social protection programmes or universal healthcare; and no repeat of the past month’s shabby spectacle for at least 15 months. All of this was in doubt even a week ago, as congressional intransigence threatened to make the problem of raising the limit insoluble.
The Hippocratic Oath applies in economics as well as medicine, and so it is no small thing for the administration to have struck an agreement that does no immediate harm. It may well be that no better agreement was achievable, given the dynamics in Congress.
But next comes cynicism. An objective observer would now predict larger US budget deficits than a few months ago. The economic forecast has deteriorated, and it is reasonable to estimate even a half a per cent reduction in growth, averaged over 10 years, adds more than a trillion dollars to the national debt by 2021.
Despite claims of spending reductions of about $1,000bn, the agreement will also have little impact on spending during the next decade. The deal confirms the low spending levels already negotiated for 2011 and 2012, and caps 2013 spending where most would have expected this Congress to end up.
Beyond that, the outcomes are anyone’s guess. The reality is that Congress approves discretionary spending annually, and the current Congress cannot effectively constrain future actions. True, there are caps and sequester threats present in the debt limit legislation, but these are virtually certain to be reformulated in 2013. The reality was, and still is, that discretionary spending will reflect the will of future congresses.
Remarkably for a matter so consequential, the agreement the super committee will seek to reduce the deficit by $1,500bn comes without any agreement on what the baseline is from which that figure is to be subtracted. Does the baseline include the Bush tax cuts? Does it exclude tax extenders, or the annual fix on the alternative minimum tax? These and other questions are unresolved.
Such baselines arguments are mind numbing, but highly consequential. If a baseline following current policy is adopted, for instance, probably in an effort to make deficit reduction easier, it would treat the non-extension of the Bush-era high income tax cuts as a $1,000bn tax increase – hardly a likely outcome given the composition of the proposed super committee.
Economic anxiety should be our final reaction. America’s current problem is much more a jobs and growth deficit than an excessive budget deficit. This is confirmed by the fact that a single bad economic statistic more than wiped out all the stock market gains from the avoidance of default, and the fact that bond yields reached new lows at the moment of maximum apparent danger on the debt limit.
On the current policy path, which involves a substantial withdrawal of fiscal stimulus when the payroll tax cuts expire at the end of the year, it would be surprising if growth was rapid enough even to bring unemployment down to 8.5 per cent by the end of 2012. With growth at less than 1 per cent in the first half of the year, the economy is now at stall speed with the prospects of adverse shocks from a European financial crisis that is decidedly not under control, spikes in oil prices and confidence declines on the part of businesses and households. Based on the flow of statistics, the odds of the economy going back into recession are at least one in three – if nothing new is done to raise demand and spur growth.
If these judgments are close to correct, relief will soon give way to alarm about the US’s economic and fiscal future. Among all the machinations ahead, two issues stand out. First, the single largest and easiest method of deficit reduction is the non-extension of the Bush high-income tax cuts. The president should make clear that he will not accept their extension on any terms. That, along with modest entitlement reform, will be sufficient to hit current deficit reduction targets. Second, it is essential the payroll tax cut be extended and further measures, such as infrastructure maintenance and unemployment insurance extension, be taken to spur demand. If so, there is still time to confirm Churchill’s maxim that the US always does the right thing after exhausting all the alternatives.
The writer is Charles W. Eliot university professor and president emeritus at Harvard University. He was Treasury secretary under President Bill Clinton.
Copyright The Financial Times Limited 2012.