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A Poor Deal for U.S. Economy

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
August 1, 2011

A Poor Deal for U.S. Economy - a-poor-deal-for-us-economy


The U.S. debt deal announced tentatively in Washington on Sunday may have been the best that was politically possible; but it is still scarcely worthy of the name. Barring a last minute break-down in negotiations, it will save the U.S. government from defaulting on its obligations to pensioners and others. But it does not address the long-term fiscal challenges facing the nation. It does not remove the policy uncertainty that is damaging the economy. And it does not undo the severe harm to America's reputation caused by the standoff.

The package is expected to be put to the vote in both the House and Senate today. If it passes, it will put into effect $917 billion in spending cuts over ten years, with $350 billion of these cuts falling on the defense budget (for more on trends in U.S. military spending, see here ). In one sense, these cuts are not enough. When the debt wrangling began, both sides were targeting $4 trillion of deficit reduction to get the government's finances onto a sounder footing. Officials of the credit rating agency Standard and Poor's have stressed the importance of an agreement on credible deficit reduction over the long term for the United States to keep its AAA rating. To quote a recent GeoGraphics blog post, raising the debt ceiling without a serious deficit-cutting plan “still poses risks of damaging market turmoil.”

But in another sense, the cuts may be too much. As shown in CFR's U.S. recovery chartbook, the current recovery is extremely fragile. Debt-laden households are disinclined to spend. As a result, government spending is, regrettably, a necessary driver of growth. Smart deficit reduction would have reformed entitlement programs and eliminated loopholes in the tax code, putting government finances on a sustainable medium term path while not impacting short-term growth. Fortunately, the $917 billion of cuts are back loaded, but there is nothing in the package to counteract the drying up of recent stimulus spending and temporary tax cuts. This will exacerbate the problem of subpar GDP expansion, which in turn means that the debt-to-GDP will suffer.

In addition to the $917 billion of cuts, a special committee of lawmakers is supposed to come up with a further $1.5 trillion of deficit reduction, bringing the total to $2.4 trillion. The plan lays down a contingency that if lawmakers do not agree on reductions worth at least $1.2 trillion by December 23, a pre-set menu of cuts would take effect. But the uncertainty about how all this will play out is sure to be a drag on economic growth.

None of this will help the U.S. standing in the world. Already, outside commentators have seen the U.S. debt and the political system's clumsy handling of it as proof of American decline. A debt deal that extends the fraught politicking over deficit cuts through the end of this year is likely to keep this painful issue in the headlines. Also, the borrowing authority that the president has been granted will keep the government running only until 2013. In less than two years, this fight will resume again.

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