US fiscal policy slid over the fiscal cliff last month without serious damage and the next debt ceiling hurdle has been pushed back a few months. But the longer-term issues remain unaddressed. This failure to articulate a credible and sustainable budget strategy saps confidence and holds back a proper recovery.

On the surface, this problem shouldn't be too hard to fix. After all, President Clinton got a similar-sized deficit down in the 1990s and bequeathed a surplus to President Bush in 2001. At that time, it seemed the surplus was so entrenched that government debt would gradually disappear, providing some economic justification for Fed Chairman Greenspan's endorsement of the Bush tax cuts. Going into the 2008 crisis, the deficit was a modest 1.2% of GDP, even with the Bush tax cuts.

The crisis and the slow recovery changed that: the budget deficit was 10% of GDP in 2010 and now, after a couple of years of consolidation, is still 7% of GDP.

This reflects the slow recovery. Usually, economies bounce back strongly (the most dramatic example: the US economy grew at an average annual pace of 9.5% in 1933-37, coming out of the Great Depression). The recovery this time began well enough in the year following the February 2009 fiscal stimulus, but has been feeble since then. The US economy has paid a huge price for this slow recovery.

Here is the chicken-and-egg predicament: the deficit is big because the economy is operating well below potential, but debt concerns are pressuring the authorities to tighten further, thus crimping growth.

There is not much doubt that the 2009 budget boost was beneficial for the recovery, and that the budget consolidation since then has been a drag on growth. But continuation of the 2009 fiscal stimulus ran into opposition not only from the Tea Party small-government fanatics, but also from those with a well-based concern that persistent deficits were expanding the debt ratio sharply. The unhappy compromise has seen the deficit wound back through budget cuts, with the inevitable knock-on effects for growth: this year, the budget will exercise a contractionary impact of 1-1.5% of GDP, unhelpful for an economy struggling to grow at much over 2%.

With a healthy economy, the medium-term (ten-year) budget horizon would involve some tricky but manageable trade-offs. It would be possible to articulate a realistic recovery strategy involving short-term expansion and medium-term consolidation. Departing Treasury Secretary Tim Geithner has talked of a mix of short-term stimulus through infrastructure spending combined with practicable adjustments to expenditure and revenue. These adjustments would take a modest 0.5% out of the budget deficit over the next ten years, which he says would be enough to stabilise debt.

Others support this view that the revenue and expenditure changes required for debt stabilisation are not too onerous. One caveat is that these scenarios rely on getting the economy back to full potential soon, with the virtuous feedback that follows.

Superimposed on this economic scenario, however, is Washington's poisonous politics. Instead of a clear, binding commitment to such a sustainable trajectory, the US is headed for more budget drama with imminent sequesters and a revisiting of the debt ceiling in May. And the drama queens of financial markets stand ready to panic again.

If all this seems depressingly difficult, further into the future there is a still more intractable budget problem. The next decade will bring a sharp increase in the proportion of the population over 65, and thus eligible for Medicare, the most expensive of the out-of-control health entitlement programs. The health care component of the budget is forecast by the Congressional Budget Office to double over the next 25 years from its current 5% of GDP. Together with the other social programs, the budget cost of entitlements rises from 10% of GDP to 16%. Even if the federal tax take rises from the current meager 15% of GDP to exceed its long-term average of 18%, debt is forecast to reach 200% of GDP.

Health care costs are a nightmare challenge in themselves. Total health care currently accounts for over 17% of GDP, compared with an average of less than 10% in OECD countries and only 12% of GDP in the next-most-expensive country, the Netherlands.

Thus a budget solution requires cheaper ways of providing health care and the paring-back of budget entitlements. But the political context is out of step: Obama has just beaten the Republicans on tax and is in no mood to give any ground on entitlements (which would deeply disappoint his supporters). The 'Obamacare' health care initiative is his pet project, and skimping on this would be excruciating.

Sooner or later the idea of a Grand Bargain (along the lines of the 2010 Simpson-Bowles proposal) will have to be revived. Higher taxes have to be a part (and America is still lightly taxed on international comparisons, with numerous loopholes and no federal GST). 

There are, however, no signs that President Obama is ready to repeat Bill Clinton's commitment to 'focus like a laser beam on the economy'. Without this single-minded commitment to addressing the budget in both the medium term and longer term, the alternative — a succession of mini-crises followed by palliative solutions — will leave America on an anemic recovery path.

Photo by Flickr user bitzcelt.