The budget deal and Washington’s new politics of compromise

By Anatole Kaletsky
December 12, 2013

The muted market reaction to this week’s budget deal in Washington may initially seem like a disappointment. After all, uncertainty over government spending, debt and taxes has consistently emerged in business sentiment surveys as the biggest single factor holding back corporate investment and damaging financial confidence. Why then did Wall Street celebrate this breakthrough with its biggest daily fall in two months?

The standard explanation is that the budget deal will accelerate the tapering of monetary policy by the Federal Reserve Board, and that is probably a valid expectation. The main reason for the seemingly perverse response, however, is simply that this budget deal was predictable to the point of inevitability, even if most Washington pundits committed to the standard narrative of U.S. political dysfunction and gridlock did not see it coming until this week. Viewed from outside the Beltway, the inevitability of eventual bipartisan cooperation on the budget has been obvious since the 2012 election, which essentially settled all the important U.S. fiscal debates.

Having argued this position all year and having suggested back in October that a deal by this week was very likely, I could hardly be surprised that the markets greeted this event with a yawn. Short-term players on Wall Street have simply followed the time-honored formula of “buy on the rumor, sell on the news.” Business leaders and long-term investors, by contrast, are likely to be relieved and even enthused by this agreement, but their responses will have to be assessed over weeks, months and even years, not just a few days.

There are, however, several important lessons that can be drawn already from the U.S. budget agreement, several with implications for politics and economic policy in other countries. Here, briefly, are five:

1. Political analysts, lobbyists and media pundits whose professional reputations or business models depend on emphasizing or dramatizing political battles often present a misleading picture of economic policies. They naturally tend to exaggerate confrontations and underestimate the possibilities of compromise, even in situations where the interests of all the main political players point towards cooperation, rather than conflict. This principle is as true of monetary policy as of fiscal policy and it applies around the world. For example, European political analysts often exaggerate the confrontations between Germany and other countries or the risks to the euro posed by the German constitutional court or the Bundesbank.

2. U.S. politics since the 2012 election has provided a classic example of this cognitive bias. While pundits have continued to emphasize the polarization in Washington and exaggerate the power of the Tea Party, the election completely changed U.S. political dynamics by transforming the Republican Party’s incentives. Until the election, Republicans had an incentive to obstruct and even sabotage economic policies in the hope of defeating President Obama. Once the election was over, they had to start acting as responsible partners in government to avoid damaging the economic interests of their constituents and business supporters. Battles over political principles that threatened serious damage to the economy might have made sense with a few months to go before the 2012 election, but they became unacceptable to most Republican voters and financial supporters once Obama was re-installed in the White House for another four years.

3. This shifting balance of political incentives has weakened radicals and strengthened centrists in both parties. After the election, the Republicans could no longer allow the Tea Party to hold them hostage, since four years of political gridlock until 2016 would do unacceptable damage to Republican economic interests and convey the image of a party unfit to govern constructively. And once the Republicans showed willingness to compromise and isolate extremists, which they finally did in October’s government shutdown, the Democrats were forced to do the same thing or risk unacceptable damage to their political reputations and their supporters’ economic interests. U.S. politics has therefore moved gradually back towards the center after the 2012 election, instead of becoming more polarized as the standard narrative still contends. Similar dynamics have operated in other countries with coalition governments — reverting to Germany, September’s election implies more collaborative and constructive policies towards the euro from both main parties than in the year or two before the election.

4. U.S. budget deficits and national debt levels never threatened government solvency or imposed a serious burden on the economy’s long-term performance, as was often claimed. As the U.S. economy has resumed economic growth, the seemingly unsustainable deficits have melted away. After the partial cancellation of the Bush tax cuts in last January’s fiscal cliff deal, the U.S. budget problem was essentially solved and there was no need for any further fiscal tightening. Once it became clear that the deficit was no longer a genuine economic problem, the budget battle became a political charade. With no need either for the tax increases demanded by the Democrats or for the spending cuts demanded by the Republicans, a compromise acceptable to both sides became feasible. Instead of both sides being forced to accept policies they hated,  they both merely had to stop demanding policies their opponents hated.

5. At some point in the future, tax increases or public spending cuts may well be necessary for the U.S. But the scale of any future fiscal challenge is impossible to gauge today, since it will depend entirely on how the U.S. economy performs in the years ahead. If major fiscal reforms are needed after 2016, the time to debate them will be the next presidential election campaign. At that point voters can decide whether the fiscal challenges of demographics and rising health costs should be met through higher taxes or reduction in age-related spending or, most likely, a combination of both. But until 2016, the only deficit-reduction policy the U.S. needs is economic growth. And this is the main lesson from U.S. experience for other countries. Economic growth is the key to deficit and debt reduction. Tax increases or spending cuts that weaken growth are not just politically unpopular and economically counter-productive, they are fiscally irresponsible, too.

PHOTO: House Budget Committee chairman Representative Paul Ryan (R-WI) (L) and Senate Budget Committee chairman Senator Patty Murray (D-WA) hold a news conference to introduce The Bipartisan Budget Act of 2013 at the U.S. Capitol in Washington, December 10, 2013.  REUTERS/Jonathan Ernst 

4 comments

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Great column!

Posted by jrpardinas | Report as abusive

Really good article. One clarification concerning Germany and its society and politics as the country was mentioned a few times.
Germany is a homogeonous country, there is more diversity in any of 50 states than in whole Germany (low Gini index, no poverty and not many super rich).
The same concerns German politics. After September elections 2 biggest parties created a Grand Coalition.
To make a long story short there are more political differences within the Democratic Party and within Republican Party than between Grand Coalition partners.

Posted by Wantunbiasednew | Report as abusive

If the incentives for the current political environment favor compromise, then what were the incentives prior to the 2012 election that led to obstruction and gridlock? If the Republicans are shifting away from confrontation because doing so harmed their constituents, well wasn’t that true before the election as well? What exactly changed?

Posted by delta5297 | Report as abusive

U.S. Budget deficits and the national debt never posed a threat to the economy? At some point in the future tax increases or spending cuts may be necessary?
How very intellectual.
If it is too painful to face these issues now, how devastating will it be when these things come to a head? Don’t worry, our kids will pay for it.
I do agree that economic growth is A key to deficit reduction but how is our country going to grow its way out of this mess when our businesses are burdened with tens of thousands of pages of new regulations each year?

Posted by urukhai2 | Report as abusive