Thursday, April 7, 2011

The politics of fixing structural budget deficits

Without a political agreement by the end of the week on US government spending for the remainder of the 2011 fiscal year, all non-essential US government services will cease. Welcome to the politics of “dealing to” large structural budget deficits.

You might recall at the time of the US mid-term elections last year that amongst the market positive reaction to the election outcome, we warned the Administration’s loss of control of the House would be problematic as they sought to deal with the long list of economic and financial challenges. Luckily the Democrats only lost control of the House, not the Senate.

Now representatives of both sides of the House that are trying to cobble together a spending plan to get to the end of the fiscal year (September). At the centre of the debate is an extra US$7 billion of spending cuts the Republicans want to see on top of the US$33 billion already proposed by the Administration to get them through to the end of Fiscal 2011.

Let’s remind ourselves that a discussion over US$7 billion is the tip of the iceberg. The US Budget deficit this year is likely to be around US$1600 billion, or US$1.6 trillion. US$7 billion in fiscal 2011 is a side issue to the real debate about the long-term sustainability of US fiscal policy. Indeed the Republicans are currently working on their plan to cut the deficit by three-quarters or a cumulative US$6 trillion over the next decade.

If talks fail in the next 24 hours should we be worried about a partial shutdown of the US Government? I’d argue “No”. The US has been here before, and not that long ago, in 1995. So while this is not a common event, neither is it a new experience.

Furthermore, no one really wins from these sorts of political games. In fact if any government shutdown becomes too long and/or too disruptive, phrases such as “holding the country to ransom” will quickly (re)enter the popular political vernacular. That’s a no-win situation for any political party. That means any impasse should be quickly resolved once all sides think they have won something.

The current (small) problem is symptomatic of the political road ahead as Governments realise that big budget deficits are structural and that current forecasts of fiscal consolidation are overestimating the likely positive impact of the improving economic cycle. Big spending cuts and/or tax increases will be required. That makes for tough politics. Remember footage of rioting over Budget cuts in Europe where many countries are ahead of the US in the austerity cycle (albeit out of necessity).

This is made all the harder by the fact that given the size of current budget deficits, cuts will have to be made in the larger spending items – entitlements.

There is a tough political road ahead. The upside is that done well, fiscal consolidation will reduce the amount of work that needs to be done by interest rates in the period ahead.