Wednesday, July 20, 2011

All eyes on the politicians

Over the next few days the big news will be the politics of debt – both in the United States and Europe (more on Europe tomorrow). The US is perilously close to breaching its $14.3 trillion debt ceiling. Indeed it has already been breached, but via accounting measures employed by the US Treasury, more time has been secured to find a solution.

The US Senate is to remain in session until a solution is found. It is necessary to find a solution in the next few days so that legislation can be passed before the August 2 deadline. President Obama has described a new plan put forward by the so-called “Gang-of-Six” as being broadly consistent with what he is seeking.

Fiscal consolidation was never going to be easy. Many politicians don’t like cutting spending and many don’t like raising taxes. None of them like doing both at the same time. The politics are undeniably challenging, especially given the Democrats don’t control the House of Representatives.

That’s why at the end of last year following the US mid-term elections we wrote that markets should be careful what they wish for. You will recall markets responded positively to Obama losing control of the House. The theory was it would curb Obama’s supposed regulatory inclinations. We argued at the time that over the next few years, as tough fiscal decisions had to be made, it was desirable to have a strong US President, regardless of political affiliation so that the hard fiscal decisions would get made.

Whatever the make-up of the fiscal consolidation plan, fiscal policy is going to provide a significant negative impulse to economic growth in the US and many developed economies for a number of years to come. That will be exacerbated by the good work that households are doing to reduce debt levels.

The good news that comes with that is two-fold. Firstly, it reduces the amount of work that monetary policy will need to do as economies hit (lower) capacity constraints. Secondly, while economic growth will remain soft for a significant period of time, important repair work is happening behind the scenes that makes the recovery, albeit soft, increasingly sustainable.