For now, Europe's voters roil the markets. Soon, investors will be fretting about Florida and Ohio. The US election in November will have unusually immediate and dramatic consequences for the economy. A recent investment bank conference call concluded with the advice that clients should "buy volatility". Translation: be scared.
It is easy to see why. At the end of this year, tax cuts introduced by President George W. Bush will expire unless legislative action is taken – meaning the US Congress will have to come up with a tax law that the president is prepared to sign. Spending cuts enacted last year will also come into effect unless a legal change rescinds them. And other props to the recovery – from a payroll tax holiday to a temporary extension of unemployment insurance – are due to wind down. To complicate things further, the federal government will once again be up against its debt ceiling. Last summer, raising the ceiling involved an unseemly food fight that cost the US its triple A credit rating.
These pressures might be welcome if they forced compromise in Washington. But the omens are bleak. Rather than seek a mandate to eliminate tax loopholes and discipline health spending, which are the two central components of any intelligent budget fix, candidates on both sides resort to sound bites.
Nor is the likely election outcome reassuring. The most reliable predictor of presidential races is the Iowa futures market. It tells us that President Barack Obama is likely to retain the White House, and that Republicans will keep hold of the House of Representatives and may capture the Senate. In this scenario, each side will feel it has won a mandate. Neither will be keen to compromise – especially not on a complex issue in limited time.
If gridlock prevents legislative action, we will get what has come to be known variously as the "fiscal cliff" or "taxmageddon". Or, if gridlock leads to holding action but ducks the fundamental problem, the consequences could be as dire. The president and Congress might play for time, extending existing tax and spending laws without grappling with healthcare or tax loopholes. The federal government would then have reaffirmed its inability to get its fiscal house in order. Another credit downgrade would follow.
Which outcome would be scarier? In the eurozone, the answer would be obvious: premature fiscal tightening has made debt-to-gross domestic product ratios worse. But the US is not Europe, as is clear from the Congressional Budget Office's latest forecast. Its "baseline" projection, which assumes that tax cuts wind down as scheduled and that Congress does not cancel enacted spending cuts, forecasts that the economy would actually grow by 1 per cent next year. This makes sense, because a sharp rise in government saving would be partly offset by a fall in household saving, as consumers absorb the tax hit gradually. Because the CBO forecast was completed in December, before Congress enacted more stimulus, the cliff has since grown steeper, making the 1 per cent forecast a bit rosy. The likeliest bet is that the first half of 2013 will bring a mild recession.
Of course, even a mild recession would be painful. Prolonging long-term unemployment will remove people from the workforce permanently. But the alternative scenario is not attractive. The CBO's analysis shows that, if the fiscal "cliff" is sidestepped, growth will initially be stronger but federal debt as a share of GDP will spiral out of control. Federal debt (excluding that held by the government) stands at 73 per cent of GDP. In a decade, it would stand above 90 per cent. The cost of servicing that debt would depress future growth. And after the next credit downgrade or the one after, investors may demand higher returns on treasuries, pushing up the debt burden still more.
Admittedly, after the last downgrade nothing much happened. If taxmageddon is averted, however, things could play out differently next year. There will be no quantitative easing to underpin the Treasury market, and interest rates will probably already be rising; so a hit from the rating agencies would catch Treasuries on the back foot. Throw in the worry that the Federal Reserve will misjudge the exit from its extraordinary easing, causing a jump in inflation, and you have the makings of a bond market dive.
In short, there are two plausible results from gridlock in the post-election "lame duck" Congress: either a recession or the risk of market trouble. The way out of this dilemma is to avoid gridlock in the first place. However, this would require politicians to win a mandate for intelligent fiscal overhaul. The time to ask for that is now.
The writer is Paul A. Volcker senior fellow at the Council on Foreign Relations and an FT contributing editor.
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