The US remains in a fiscal pickle

Barack Obama emerged triumphant overnight, but the debt battle has done ongoing damage to the US recovery. And debt ceiling uncertainty will inevitably re-emerge within months.

It is a huge win for President Obama with the budget and debt ceiling siege in the US over, at least temporarily, with an eleventh-hour deal to pass the budget and increase the debt ceiling.

The cranks in the Republican Party in Congress have been humiliated, caving in to the agenda set by Obama. Obamacare is untouched.

The deal, as it appears at the time of writing, is that the debt ceiling will be increased until February 7, 2014 with the budget measures extended to January 15, 2014. While the deal is welcome – with the stock market higher, bond yields and the US dollar lower – the solution is clearly very short term and within three months, the uncertainty over the budget and debt ceiling will inevitably re-emerge.

An optimist would hope that in that time, policy makers in Congress will look at the core issue dogging the US economy – the chronic budget deficit and debt position (The Tea Party’s bitter Japanese flavour, October 14). Tax hikes as well as spending cuts are needed if the US is ever to register a balanced budget. This means that the Republicans will have to soften their view on tax if the US is to get out of its fiscal pickle.

This seems highly unlikely, which means there will almost inevitably be more economic and market ructions ahead.

The real worry is the damage this episode has done and will continue to do to the economy.

Up until a few weeks ago, there were signs the US recovery was gaining traction. Jobs growth was decent and the unemployment rate was trending lower. Housing construction and prices were firmly higher and business optimism was consistent with the economy expanding at an above trend pace. The economy was looking so good that the market was convinced the Federal Reserve would start a monetary policy tightening cycle very soon.

The actions of the Republicans will likely undermine that favourable news but are likely to ensure the Fed keeps buying bonds as it works to keep the growth trajectory in place. The Tea Party, which thinks the Fed should not exist, hates quantitative easing but its actions are all but ensuring QE will remain a central plank of the Fed’s policy settings.

Such is the folly of their actions.

Not everyone was pleased with the Republican capitulation. The Washington Post reported that the head of the Tea Party Patriots, Jenny Beth Martin, said "the Senate deal is a complete sellout.  Speaker Boehner and the House should stand firm and reject this deal to reign in the executive branch’s power before it is too late.”  

Martin added, “The House ‘leadership’ must stop playing ‘flinch’ with themselves, and instead, play hardball with the White House, the Senate, and the House. Otherwise, hard-working Americans are going to bear the burden of this unaffordable law (Obamacare). The American people will hold those responsible for this mess accountable.” 

With views like that, US budget policy and the debt ceiling issue could well remain potential threats to the functioning and growth momentum in the economy. It will take leadership from the Republicans to overcome this paranoia.

The end point of all of this is that the solution to the current impasse is temporary and the damage to the reputation of the US as a financial safe haven is severely damaged. The US dollar reserve currency status continues to erode as investors will increasingly shy away from the risks associated with holding US bonds. It is difficult to think that the central banks of China or Japan, for example, would be all that keen to add to their US Treasury holdings in the medium term. And in fact, with markets calm for now at least, they would be more inclined to run down their holdings.

The US dollar seems a one-way bet – lower.

For the US, with large and perpetual budget deficits for as far as the eye can see, this will create severe problems. Yields will have to rise to entice investors, but this will risk choking off growth and thereby mean more QE is needed and that the fiscal position will deteriorate.

It is an unpleasant scenario. 

And all this for the sake of some misplaced Tea Party Republican political posturing and no real proposals to fix the fiscal mess, which was in large part the making of the Bush administration in the period from 2000 to 2008.