Editor’s Note: This is an edited version of an article from the ‘Oxford Analytica Daily Brief’. Oxford Analytica is a global analysis and advisory firm that draws on a worldwide network of experts to advise its clients on their strategy and performance.
The world is becoming used to political polarization in the U.S. Congress. Expectations were so low that global reaction to yesterday’s failure by the bipartisan congressional super committee to agree on significant deficit reduction has been subdued.
Markets’ tepid response suggests that the short-term significance of the outcome is limited: It merely postpones necessary fiscal reforms until after presidential elections next November. However, the political implications are significant. And by contributing to perceptions of Washington’s ‘dysfunctionality’ - in the context of Europe’s growing sovereign debt crisis - the failure risks undercutting economic confidence and recovery.
Yet the super committee's failure does not signal that the United States is incapable of addressing such challenges. Indeed, it is arguable that prospects for major fiscal reform are steadily increasing. The failure triggers 1.2 trillion dollars in statutory ‘automatic’ spending cuts from October 2012 (fiscal year 2013). Despite current pessimism, Congress is likely to authorize about 3 trillion dollars in additional consolidation (over a decade) in 2013 - eliminating risk of a fiscal crisis over the medium term.
The three most politically fraught aspects of comprehensive budget reform cover entitlements, tax increases and defense cuts. The ‘automatic’ cuts will directly affect Pentagon spending, set to shrink by 9%. The Pentagon must now find ways to reduce outlays by 55 billion dollars a year until 2021 - on top of reductions expected by winding down operations in Iraq and Afghanistan - severely affecting its planning, procurement and personnel. Congressional Republicans have said that they will redirect some cuts away from defense, but the President has vowed to veto any such move.
Fiscal consolidation at this pace and magnitude could be economically damaging. On one hand, the Congressional Budget Office estimates that if Bush-era tax cuts are allowed to expire fully at the end of next year, an estimated 3.9 trillion dollars in additional revenue could be generated over ten years. The tax increase would - together with reduced defense spending and other automatic reductions - slash the annual federal deficit from 1.3 trillion dollars (8.7% of GDP) to just 510 billion (3.4%).
On the other hand, reform this abrupt carries a significant risk of slowing growth and causing renewed recession. Expiry of the Bush tax cuts is thus likely to be delayed. Obama has indicated that if re-elected he would apply the increases only to households with incomes over 200,000 dollars a year.
A decision not to further tax the middle class leaves a revenue gap in 2013. This is likely to be made up through entitlement reform, mainly on social security (pensions) and Medicare. If Obama is president, these reforms will be relatively minor, yet still produce perhaps 1.5 trillion dollars in additional consolidation over the next decade. If Mitt Romney (his most likely opponent) wins in November 2012, he will attempt more aggressive change. Either way, fiscal consolidation is likely to be significantly larger than planned at present, and spread out more over time - so reducing negative effects on growth.
In the short term, the focus is on Congress. Through its recent actions (‘debt ceiling’ brinksmanship) and inaction (on the super-committee), Congress has significantly increased the country’s vulnerability to an economic crisis in the euro-area (a chronic sovereign debt problem that may shift into an acute banking crisis), despite the U.S. economic outlook otherwise appearing relatively resilient.
Public reaction to the super-committee failure ranged from concerned to annoyed - reinforcing prevailing views of an institution with approval ratings mired at all-time lows (13% in a November 14 Gallup poll). Gallup polling also suggests a majority of the public (60%) want a compromise that involves both spending cuts and revenue increases - with an emphasis on the former. This points to public support existing for likely post-2012 fiscal reforms.
However, weak business indicators ahead of the holiday season indicate that businesses have adopted a highly risk-averse position. This explains a downward revision to estimates of growth in the economy in the third quarter of this year. Again the focus turns to Congress: Extending and expanding payroll tax cuts, a measure it will consider within days, will be critical to shoring up confidence as the year ends.
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