Renewed optimism can be a double-edged sword

May 2, 2013

This is a critical week for the world economy and financial markets, especially in the United States. Friday’s U.S. employment report will signal either a renewal of the economic recovery or, much more likely, will confirm that the economy is sinking into another seasonal “soft patch” for the fourth time in four years. Despite this risk, stock prices on Wall Street are at record highs, suggesting that equity investors see this slowdown as nothing more than a temporary obstruction on the way to a sustained recovery, just as in the summers of 2010, 2011 and 2012. So should we prepare for more anxiety about a double-dip recession, or can we feel confident that this summer will be followed by an autumn of strong recovery, as in the past four years?

I had an excellent vantage point this week from which to assess this question: the global conference of the Milken Institute in California, which brings together 1,000 business executives, politicians and financiers in a U.S. equivalent of the Davos economic forum, transplanted to the warmer and even plusher surroundings of Beverly Hills. Clearly, there was anxiety about the flagging recovery and the self-inflected damage caused by January’s payroll tax hike and the unplanned cuts to public spending caused by the sequestration process. But there was also a palpable resurgence of optimism about America’s long term prospects: the opportunities created by 3 billion new global consumers; the U.S. track record of innovation and enterprise; the magnetism of U.S. universities for global talent; the promise of energy independence; the transformational opportunities from “big data” and robotics; the prospect of liberalized immigration policies; and, encompassing many of these issues, a sense that the hyperpartisan warfare in Washington over healthcare, taxes and public spending had reached a point of exhaustion. Both sides, it seems, might be ready for a ceasefire, if not yet a lasting peace.

A surprising highlight of the conference was an amiable hour-long discussion between two of the most partisan antagonists in Washington’s political dramas ‑ Senate Majority Leader Harry Reid (D-Nev.) and Eric Cantor of Virginia, the ultra-conservative leader of the Republican majority in the House of Representatives. This ended with both politicians agreeing that there might be scope for a deal on the U.S. budget and thanking the Milken Institute for bringing them to California so they could talk to each other constructively in a way that simply isn’t possible in Washington. Similar sentiments came from leaders of both parties, ranging from Tennessee Republican Senator Bob Corker’s appreciation that “President Obama has put himself to the right of the House Republicans on entitlement reform” to Senator Bob Casey, a Democrat from Pennsylvania, saying that “so many people have become intolerant of hyperpartisanship – this is an even bigger issue for voters now than unemployment.”

If U.S. politics is edging away from internecine warfare, this has big implications for the world economy ‑ not all of them positive. The good news is policy predictability and stability. Even the staunchest conservatives, such as Cantor, have accepted that Obama’s main legislative achievements will not be reversed. They are learning to live with healthcare reform (now generally by its official name, the Affordable Care Act, instead of the contemptuous “Obamacare,” even by Cantor). They are embracing immigration reform, and some are even calling for greater government activism in areas such as education and healthcare research.

At the same time, Democrats have sobered up after their electoral celebrations and are realizing they may have to accept some long-term reductions in health and pension entitlements if they want to defend the discretionary spending priorities they hold dear: welfare, education, infrastructure investment and so on. As Peter Orszag, President Obama’s former budget director, noted, “I tell my friends on the left [of the Democratic Party] that there is a concern in the country about deficit reduction that they can’t ignore – it’s like an itch and it is going to get scratched. So if you don’t do entitlement reform in the long term, you will do too much on discretionary spending in 2013 and that is the most dangerous kind of deficit reduction.”

Which leads to the bad news. The newfound spirit of bipartisan cooperation could inspire misguided economic policies that delay recovery and damage the world economy. This is exemplified by the way recent tax hikes and spending cuts have caused an economic slowdown. The danger now is that the quest for a bipartisan “grand bargain” on deficit reduction could repeat this damaging experience of fiscal tightening ‑- on a grand scale.

President Obama’s current idea of a deficit bargain has Democrats agreeing to cut public spending in exchange for Republican agreement to raise taxes. Both sides of this deal will damage economic growth. The grand bargain needed at present is the opposite: an agreement by Republicans not to cut spending in exchange for a promise by Democrats not to raise taxes, at least for the next few years.

That would, of course, mean ignoring budget deficits. But that is exactly what sensible macroeconomic management demands in an economy that is far below full employment and trend growth. Once the economy recovers fully, some gradual reductions in entitlement spending and moderate tax increases may well be appropriate, but the time for such fiscal tightening will not be until a new Congress arrives in Washington in 2015 and maybe not even until a new president is inaugurated in 2017. Whatever deal on long-term deficit reduction might be agreed to in Washington this year is certain to be altered by unpredictable events and is likely to be unraveled by a future president and Congress. Instead of spending huge amounts of political capital on promises that might or might not be kept by their successors, Obama and congressional leaders could serve the U.S. economy better with a very different grand bargain: to stop worrying about deficits and guarantee not to damage the recovery any further with spending cuts or tax hikes.

PHOTO: (L-R) U.S. Congressman and House Majority Leader Eric Cantor (R-VA), Milken Institute Chairman Michael Milken and U.S. Senate Majority Leader Harry Reid (D-NV) take part in a panel discussion titled “The Awesome Responsibility of Leadership” at the Milken Institute Global Conference in Beverly Hills, California April 29, 2013. REUTERS/Gus Ruelas

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