Fight over US budget warm-up for battles to come

Washington has achieved almost nothing on fiscal policy this year. Had you ignored every article and ranting speech, every sober analysis, projection, last-minute deal and madcap 9-9-9 tax plan for the last twelve months then your knowledge of public finance in the world’s largest economy would barely be out of date.

The record of pointless activity is quite remarkable. US President Barack Obama set the tone when he shelved the recommendations of his Simpson-Bowles fiscal commission. A series of pint-sized spending deals through the spring were an appetiser for the year’s main fiasco – a near failure to raise the nation’s debt ceiling in August – which in turn spawned a ‘supercommittee’ which, in turn, failed.

Even the one almost-substantive piece of legislation, August’s Budget Control Act, was a bit of an illusion. It set caps on minor areas of spending for the next decade but by 2020, the supposed limits are so pip-squeakingly tight that they will never be met unless libertarian Ron Paul becomes president and shuts down half of the federal government.

Not content with this record of legislative achievement, Republicans in the House of Representatives are determined to have one more scrap about the status quo – this time over an extension of the 2011 payroll tax cut into 2012 – even though much of Congress has already given up and gone home for Christmas.

If the payroll tax cut does get through, then taxes and spending in 2012 will be similar to that of 2011. For the economy, this budget gridlock has been both good and bad news. On the positive side, the traffic-jam-in-LA level of immobility has led, by default, to a broadly sensible fiscal policy. Unlike countries such as the UK, which have tried for a rapid fiscal consolidation, the US is withdrawing stimulus gently as measures passed in the crisis expire.

On the negative side, however, all of the budgetary noise is bad for short-term confidence in the economy and worse for the long-term prospects of a budgetary agreement that tackles the real issues: rising healthcare and pension costs and an unwillingness to levy enough tax to pay for them.

The argument about the payroll tax cut is a case in point. If there is no extension, then the immediate effect on the economy will be fairly small. The $120bn cost is less than 1 percentage point of annual gross domestic product. So a temporary expiry would shave less than 0.1 per cent from output if it was reversed by Congress before the end of January.

As with the dust-up over the debt ceiling in August, however, the short-term problem is not the direct effect but the clear and repeated message that Washington is willing to gamble with the economy. The doctors have had a screaming row in front of the patient; refused to agree on treatment; and gone home in a sulk without prescribing any painkillers. It may not do physiological harm but any patient with a nervous disposition is going to suffer.

The long-term concern is what it says about the prospects of a deal on entitlements and paying for them if the institutions of Congress cannot even reconcile small budgetary differences a week before Christmas. A deal grows more costly with every year that reform is delayed.

Serious budgetary players in Washington have long argued that the real window for a fiscal deal is at the start of 2013. It is not a coincidence that $1,200bn in spending cuts under a sequester mechanism are scheduled to start then, just as the tax cuts passed by former president George W. Bush expire, and a new presidential term begins after an election fought over the economy.

With everything changing, everything can be made anew. Tax hikes and spending cuts are certain to happen unless there is a deal so legislators should have every reason to reach an agreement that tackles the deeper budgetary issues.

The 2012 election, however, may not produce the clear mandates that make a good deal possible. A quite plausible scenario is that Mr Obama wins re-election under the banner of scrapping the Bush tax cuts, while Republicans take control of the Senate under the banner of keeping them. That argument could make this year’s disputes look like a warm up – and have truly grave consequences for the economy.