The budgetary wars holding America back

Whatever happens at the next fiscal cliff on March 1 will subtract further from 2013 growth prospects. And the ongoing fiscal attrition in Washington between Republicans and Democrats is set to last years.

Last week Barack Obama put his hand on the bible, swore an oath of office and gave Republicans the middle finger. Two days later they caved in on their threat to hold the debt ceiling hostage (or at least until May). So much for the drawbacks of the president sounding too liberal.

But the "let Obama be Obama” crowd might be counting their fiscal chickens too soon. The Republicans did not walk away from the game of US budgetary poker. Their new and less self-destructive tactic is to drag it out.

From Obama’s point of view, it is better to contemplate a war of fiscal attrition than the threat of a sovereign debt default. But the economic costs from whatever deal – or series of mini-deals – that emerge in the coming months are unlikely to be trivial.

The first and most immediate is to 2013 growth prospects. As both Lawrence Summers, Obama’s former senior economic adviser, and my colleague Martin Wolf pointed out last week, there is nothing about the anaemic US recovery that merits austerity at this point. America’s fiscal crisis is political. Anyone doubting that should check with the bond markets, which in real terms continue to pay the US Treasury for the privilege of lending to it.

Last month’s deal to avert the original fiscal cliff imposed a budgetary contraction of roughly 1.5 percentage points of US gross domestic product. Most of that hit came from the decision to allow the holiday on payroll taxes to expire – an ill-timed move from a cyclical point of view.

Whatever happens at the next fiscal cliff on March 1 – whether it triggers a full spending sequester of $110 billion or a deal to cut spending and raise revenues by a similar amount – will subtract further from 2013 growth prospects. At a point where the US could be experiencing catch-up growth to make up for the output lost since 2007, Washington is importing European austerity.

Second, as we saw with the expiry of the payroll tax holiday, the quality of Washington’s austerity tends to be poor. There are relatively harmless cuts, which will not affect future growth prospects. And there are unintelligent cuts that do. On this Democrats are as much to blame as Republicans.

In 2011 Obama agreed to domestic spending cuts worth $1500 billion over 10 years. Many Democrats have made it clear they would rather trigger next month’s sequester, which would impose another $600 billion worth of domestic cuts, than agree to any cuts in US entitlement programs – notably Medicare and social security.

To be fair, there is nothing that merits steep cuts to either program at this point. America’s entitlements crisis will only really start to bite in the mid-2020s.

But the impact in the meantime of further cuts to the portion of the US budget known as domestic non-defence discretionary spending will be damaging. It is the smallest part, accounting for 19 per cent of federal outlays. Yet it is the most important for future US competitiveness: it includes infrastructure, research and development, education and worker training.

Alas, it is the only area on which Republicans and Democrats have so far been able to agree. Most Republicans would rather protect defence, which accounts for almost a fifth of spending. And most Democrats would rather preserve entitlements, which now gobble up more than half (debt interest payments make up the remainder). Domestic spending is already heading to a postwar low of 2.7 per cent of GDP (from an average of 3.9 per cent), according to the Centre on Budget and Policy Priorities, a liberal think-tank. It looks destined to fall further.

Third, there is the opportunity cost from the protracted budgetary battles. Last week Obama gave an inaugural address about what he would like to accomplish in his second term. It was almost entirely domestic – not a single foreign country was mentioned. Perhaps its most impassioned section was about tackling global warming, which Obama made clear would be his biggest ambition, more so even than immigration reform and gun control. The longer the budgetary wars continue, the less room Mr Obama will have to pursue these goals.

The fiscal calendar already takes us up to May, when the debt ceiling expires. But it seems unlikely the wrangling will end there. Last week John Boehner, the speaker of the House of Representatives, accused Obama of "trying to annihilate” the Republican party. In truth, Republicans have been doing most of the work themselves. But Mr Boehner’s assessment is shared among Republican lawmakers who see Obama as the most partisan president in their lifetime. It does not matter whether their verdict is true. All that matters is that Republicans believe it to be.

Boehner went on to say that he was "up for the fight” with Obama. His chosen battleground is fiscal. And he has plenty of weapons available, from the March 1 sequester, to the March 27 potential government shutdown, all the way to the May debt ceiling, which he will want to keep on as short a leash as possible – three or six-month extensions rather than the two years Obama has requested.

Last week Boehner beat a tactical retreat on the debt ceiling. It was a smart political move. If he can control his party he will try to eke this one out for as long as possible. None of which would be good for US growth.

Copyright The Financial Times Limited 2013.

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