The debt deal in sight - but what next?

To the relief of financial markets from the Far East to London and by now Wall Street, the congressional leadership appears to have a debt limit deal to hand.  Assuming that it gets approved by both Houses, however, the debt problem is simply moving onto a different level rather than being resolved.

There's still a danger that the current imbroglio over debt limitation will result in a downgrading of the US debt by credit rating agencies.  That's less serious than would have happened in the event of a default, but lenders could interpret it as signaling that the US is no longer risk-free in terms of debt repayment.

More significantly for those of us more interested in the impact of the debt issue on ordinary people, there's a lot of politics still left to flesh out the details of the debt limit agreement.  There's still room for revenue enhancement and a portion of the spending retrenchment will come from the rundown of US involvement in Iraq and Afghanistan.  But that still necessitates a big bite out of federal domestic spending.

Whatever the distribution of the eventual fiscal retrenchment that will follow a debt limit deal, the effect on the economy is likely to be contraction.  There is a school of economic thought which argues that fiscal austerity brings expansionary benefits because it persuades financial markets that interest rates can be lowered.  However a IMF study of fiscal policy stretching back to the 1930s concludes that fiscal consolidation is much more likely to result in economic contraction than expansion.  The lesson from this is that boom times are best for budget retrenchment, as the 1990s showed.

The danger facing the US is that a political concern for debt reduction in the short-term makes it difficult to sustain long term by harming prospects for economic growth.  The US needs to cure its public debt habit and its private one, but it has still not made up the economic ground lost in 2007-09.  In these circumstances, new IMF head Christine Lagarde has suggested that its best option is to announce the details of a credible fiscal plan but delay its implementation until the economy is fully recovered.  That's the sensible solution, but the recent history of budget politics does not encourage optimism that such an approach will be adopted.