Five days that shook America

There was fictional movie called "Seven Days in May" about the foiling of a military coup in the United States. There's unlikely to be a film called "Five Days in August" because it's difficult to see how the real events of this time can have a happy ending.  These were certainly five days that shook America, beginning with the last minute congressional agreement over the debt limit, proceeding to stock market turmoil, and ending with the S&P downgrade of its debt.  

The downgrade of the debt was something of a national humiliation - "it's hit the self-esteem of the United States, the psyche" Alan Greenspan pronounced.   Some commentators spoke of this as the moment that marked the end of America's global economic hegemony.   America's biggest creditor, the People's Republic of China, made angry noises about the US having to mend its indebted ways, rather like parents telling off a teenager off about misuse of the credit card that they were financing. The downgrade will almost certainly lead to higher interest rates not only in the US but also virtually everywhere else (because the markets have long priced all other bonds relative to America's).  As such there will be damage to global economic growth.  However, the downgrade marks a distant fear about possible American default rather than the imminent threat of one, as exists in Italy and Spain.  The likelihood, therefore, is that China and others will still go on lending to America for some time yet.

Arguably, the debt limitation deal was the single most significant event of the momentous first week of August because in economic terms it helped to make a double-dip recession more likely, which did much to roil the financial markets, and in political terms it precipitated the debt downgrade in displaying to S&P (in its words) that "the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time on ongoing fiscal and economic challenges."   

The debt deal signaled that the US, the country that had stuck longest to expansionary policy in the financial-economic crisis that started in 2007 and is still ongoing, was now shifting to austerity mode. However, the public debt is a medium-to-long term problem, the economy is a here-and-now problem.  The most dangerous deficit facing America today is that in jobs not the public finances. Despite 17 consecutive months of private-sector job creation, the US still has 6.8 million jobs fewer and an unemployment rate 4.1 percentage points higher than at the start of the recession.

The outcome of the debt limit imbroglio was driven by political ideology rather than economic common sense.  It would have been far better to sustain or expand federal spending in the short term, particularly on infrastructure projects, as well as allowing temporary extension of the tax cuts in return for agreement over large-scale entitlement reform and tax reform (i. e. revenue enhancement) in the medium term.  Instead Congress came up with a deal that failed to support the economy or stabilize the debt.  The Republicans' new found dedication to fiscal stringency also suggests that they will hold out against other much needed expansionary actions, notably extension of unemployment compensation for workers who have exhausted their benefits and of the payroll tax cut beyond their scheduled expiry at the end of 2011.

In 2009, fiscal actions added some 1.8 percent to GDP; the debt limit deal will cost 0.3 percent GDP in 2012 and the expiry of the aforementioned temporary measures will, more damagingly, cost 1.4 percent GDP growth.  An economy already showing signs of slowing down cannot afford that loss of fiscal steam, so the danger of a double-dip recession in 2012 is very real.

 If America does suffer another downturn, the likelihood is that this will pull the global economy into another recession with it, a development that will almost certainly put paid to the Euro currency.  Without plans for growth rather than austerity, some respected analysts have warned that it could take America and much of Europe twenty years to achieve real economic recovery from the  financial crisis of 2007-08.

A recession in 2012 could well spell the end of Barack Obama's presidency.  It will make him look like Jimmy Carter did in 1980 rather than Franklin D. Roosevelt, as his supporters hoped in 2008.  Of course, FDR won reelection in 1936 when the economy had still not recovered to its 1929 level of output, but things appeared to be getting better  - as indeed they were until the policy error of shifting from stimulus to austerity led to new recession in 1937.  Obama may have had a poisonous economic legacy to deal with, but his handling of the debt limitation issue has not inspired confidence in the quality of his leadership or the strength of his convictions.  Things may still turn around for the president but it bears testimony to his parlous situation that his strongest thread of hope currently hangs on the Republicans nominating a candidate who is too conservative for America.