It's understandable that the eyeball-to-eyeball confrontation between President Obama and the US Congress should be getting all the attention now. After all, if the US has to keep its expenditures in line with its receipts, starting this week, spending will have to fall by 40%. This will not cause a debt default (interest on official debt will still be paid) but the effects would be huge on both financial markets and the economy.
Important though this problem is in political terms, it is a disastrous distraction from the very real and urgent issues in the economy. This graph illustrates the starting point:
US GDP is hardly back to the 2008 peak, employment is down 5% and unemployment is 9.2% – 5% higher than normal. (Note, incidentally, Australia's top performance among the developed countries).
In response to this cyclical weakness, the monetary policy accelerator has been pushed to the floor: the Fed funds rate is at zero. QE2 (the purchase of $600 billion of US government debt by the Fed) has finished and, as we have said often enough, its effect was so small as to be undetectable, except by those who have a vested interest in saying that it worked.
QE2 was supposed to lower longer-term interest rates further out on the yield curve. But the ten-year bond rate is essentially the same as it was when QE1 was introduced in 2008, and the ending of QE2 a month ago, if anything, saw interest rates fall. This is not to criticise Fed policy, but just to observe that it has done all it can do. The QE programs were, in effect, a statement by the Fed that it cared about the real economy, and this point has now been established. It cares, but it can't do any more.
For those who find 9.2% unemployment unpalatable, the answer is to provide a stronger fiscal stimulus. But what about the budget deficit, currently running around 10% of GDP?
The answer is to put in place specific detailed commitments to get the budget deficit down over time. This is not an impossible task — the budget was in surplus at the end of the Clinton presidency. On the revenue side, rescinding the Bush tax cuts (which overwhelmingly favoured the rich) would be a start. Progressively imposing a Federal GST (the US and Saudi Arabia are the only two G20 countries without a GST/VAT) would be a step forward.
The hardest task is on the expenditure side, and in particular, measures to rein in the projected large increase in health care expenses. This is not an issue unique to America, and there are plenty of overseas examples to show how it might be done.
The budget deficit needs to be cut, but it doesn't need to be cut right now, and to do so would almost certainly cut growth and make unemployment worse. The IMF estimates that '(a) budget cut equal to 1% of GDP typically reduces domestic demand by about 1% and raises the unemployment rate by 0.3 percentage point.'
It is pie-in-the-sky to argue, in the American context, that a fiscal contraction would be expansionary for the economy (Paul Krugman's 'Confidence Fairy'), but even President Obama has used this argument to try to get agreement with the recalcitrant opposition. Despite the hand-wringing of the credit rating agencies, there is no danger that a combination of short-term expansion and credible medium-term consolidation would risk America's AAA rating.
But instead of a debate about whether more short-term stimulus is needed, and how to fix the medium-term budget problems, we have a doctrinal confrontation which could trigger the worst of all worlds. Not only would the immediate cut in expenditures be totally inappropriate for this stage of the business cycle, but hitting the debt ceiling does nothing to address the very real longer-term problems of fiscal sustainability.
It is quite likely that a last-minute agreement on the debt ceiling will be reached in the next day or so. The tragedy of this debt-ceiling debate is that it will leave a legacy of commitments to irrelevant or senseless policies (such as glib rules on balanced budgets) while at the same time exhausting the opportunity for constructive dialogue on the real issues.