MacroScope

We heard it more than once at today’s hearing of the Joint Economic Committee featuring Fed Chairman Ben Bernanke: the central bank’s low interest rate policies are allowing Congress to delay tough decisions on long-term spending.

As U.S. senator Dan Coats asked pointedly: “Is the Fed being an enabler for an addiction Congress can’t overcome?”

Yet, if you read the subtext of Bernanke’s testimony closely, it may actually be Congress that is enabling a loose Federal Reserve.

That’s because it is the very fiscal tightening mandated by Congressional inaction that is forcing the Fed to continue stimulating growth. Chicago Fed President Charles Evans said on Tuesday the economy could be expanding as quickly as 3.5 percent were it not for the fiscal drag from Washington.

Bernanke echoed that sentiment in his testimony on Wednesday:

The Congressional Budget Office estimates that the deficit reduction policies in current law will slow the pace of real GDP growth by about 1-1/2 percentage points during 2013, relative to what it would have been otherwise. In present circumstances, with short-term interest rates already close to zero, monetary policy does not have the capacity to fully offset an economic headwind of this magnitude.

Evidence that Europe’s austerity policies are not working was in ample supply this morning. The euro zone as a whole is now in its longest recession since the start of monetary union. France has succumbed to the region’s retrenchment. Italy’s GDP slump is now the lengthiest on record. And Greece, still in depression, shrank another 5.3 percent in the first quarter.

To understand why this is happening, Brown University professor Mark Blyth says it is necessary to forget everything you think you know about the euro zone crisis. The monetary union’s troubles are not, as often depicted, the result of runaway spending by bloated, profligate states that are finally being forced to pay the piper. Instead, argues Blyth, it is merely a sequel to the U.S. financial meltdown that started, like its American counterpart, with dangerously-indebted risk-taking on the part of a super-sized banking sector.

In a new book entitled “Austerity: The history of a dangerous idea,” Blythe writes that sovereign budgets have come under strain primarily because taxpayers of various nations have been forced to shoulder the burden of failed banking systems.

Britain’s independent Office for Budget Responsibility slashed its growth forecasts for this year ahead of George Osborne’s Budget on Wednesday. But looking longer-term, it now has the unusual distinction of being more optimistic about Britain’s long-term economic health than the Bank of England, often pilloried for its rose-tinted views.

And rightly so. The Bank’s famed GDP fan charts have been exceptionally over-optimistic. Until recently, it routinely suggested the economy was more likely to grow more than 5 percent annually than contract even slightly, which was plainly absurd.

In its short life, the OBR too has had its fair share of forecasting blunders. Created with the arrival of the coalition government in 2010, that June it predicted 2012 GDP growth of 2.8 percent. In Wednesday’s report, it estimated the economy instead grew 0.2 percent last year.

After two days of testimony from Federal Reserve Chairman last week in which he decisively criticized Congress’ decision to slash spending arbitrarily in the middle of a fragile economic recovery, a report on money market funds from the New York Fed nails home the point.

The paper’s key finding is that, as most observers already knew, investors were a lot more worried about a break-up of the euro zone in the summer of 2011 than they were about U.S. congressional bickering over the debt ceiling.

But as Americans face a series of regularly schedule mini-eruptions in the fiscal policy arena, the authors conclude with a thinly-veiled warning to lawmakers:

Despite the Obama administration’s cataclysmic warnings about the effects of $85 billion in looming spending cuts known as the “sequester,” chances are the lights will not go out when they kick in this weekend. Still, the economic impact could be significant. The cutbacks might shave a half percentage point or more from an economy that is forecast to grow around 2 percent this year — but which only mustered a 0.1 percent increase in annualized fourth quarter GDP. This, at a time when a similar austerity-driven approach has left much of Europe mired in recession.

Both the public and the markets seem to be taking Washington’s latest war of words in stride. After all, people are becoming inured to the regularly scheduled fiscal crises that have become a part of the capital’s landscape. But the sequester’s most frightening potential consequence is much broader than its near-term economic ripples. The real danger is that, with every new episode of political theater over the budget, America’s credibility as a serious, trustworthy nation is eroded. The concept of political risk, once reserved for banana republics in the developing world, is now very much alive in the United States. And that is one liberty a debtor nation cannot afford to take.

For those who thought the euro zone had lost the power to liven things up, today should make you think again.

ITEM 1. The European Central Bank meeting and Mario Draghi’s hour-long press conference to follow. Rarely has a meeting which will deliver no monetary policy change been so pregnant with possibilities.

Draghi, the man tasked with becoming the European bank regulator on top of all his other tasks, will face some searing questioning on his time as Bank of Italy chief and what he knew about the disaster that has befallen the country’s oldest bank, Monte dei Paschi.

It doesn’t sound sustainable but, at least in coming months, businesses look set to keep booming even as consumers come under pressure – in line with the recent trend. That’s because the economic hit from the partial deal on the fiscal cliff will hurt salaried workers disproportionately, says Steven Ricchiuto, chief economist at Mizuho.

He writes:

Although the worst of the fiscal cliff has been avoided, the compromise is not macroeconomic neutral. Our calculations, in fact, suggest that the drag created by the reversal of the payroll tax cut and the various tax hikes on upper income households will cut real GDP by upwards of 0.5% to 1% from our preliminary 1.5% to 2% forecast.

Real GDP in the range of 0.5% to 1.5% this year implies that corporate profit growth will come at the expense of the wage earner. Moreover, the earnings focus assures a larger share of national income will accrue to the corporate sector. This implies another year of limited employment gains.

Budget statements from Britain and Ireland take top billing today with UK finance minister George Osborne cutting an increasingly lonely figure in policymaking circles as an advocate of cutting your way back to growth. While the economic policy room for manoeuvre is limited this is a huge political moment. With elections due in 2015, a feeling of recovery must be entrenched in the public’s mind well beforehand if the Conservatives are to entertain hopes of governing alone next time. So measures now and in the 2013 budget in the spring are the best opportunity to change the game.

Osborne has already said he is sticking to his austerity plan – and having made it the government’s central policy plank he has little choice although the opposition Labour party have staked out the opposite ground and hopes to capitalise. Even so, Osborne is likely to have to admit that he will miss his debt-cutting targets so that the pain will have to last for longer, well into the latter part of this decade.

As the euro zone has shown, without growth cutting debt is nigh on impossible. Osborne came into government in 2010 saying the austerity drive would be complete by the time of the 2015 election. He is expected to say today that it will stretch to 2018. Labour’s significant opinion poll lead is widely seen as “soft” but it might not be for long.

Social Security should not be part of the current negotiations over the U.S. budget – that was the message from outgoing Treasury Secretary Timothy Geithner over the weekend. During a veritable tour of Sunday shows aimed at addressing negotiations surrounding the “fiscal cliff” of expiring tax cuts and spending reductions, Geithner told ABC News’ “This Week”:

What the president is willing to do is to work with Democrats and Republicans to strengthen Social Security for future generations so Americans can approach retirement with dignity and with the confidence they can retire with a modest guaranteed benefit.

But we think you have to do that in a separate process so that our seniors aren’t – don’t face the concern that we’re somehow going to find savings in Social Security benefits to help reduce the other deficit.

There are signs of headway from Athens where we have just snapped a government source saying the IMF accepts Greek debt is “viable” if it falls to 124 percent of GDP in 2020, rather than the 120 that it had previously decreed was the maximum sustainable level.. The source said fresh measures have been found to reduce debt to 130 percent of GDP by 2020, leaving another 10 billion euros to be covered.

At the latest failed meeting of euro zone finance ministers on Tuesday, we confirmed that the EU/IMF/ECB troika had calculated Greek debt would only fall to 144 percent of GDP in 2020 without further measures, meaning roughly 50 billion euros needed to be knocked of Greece’s debt pile. A report circulated at the meeting concluded (apologies for the number soup) that debt could only be cut to 120 percent of GDP in eight years if euro zone government agreed to take a writedown on their loans, which they will not do for now.

If the IMF will now accept 124 percent as a target that means 20 percentage points of GDP – about 40 billion euros – would have to be lopped off Greece’s debt pile. If they are now only 10 billion short, then measures amounting to 30 billion have been found. It’s hard to believe that could have come from the Greek side which has already slashed to the bone, so maybe some or all of the options we know are on the table — a Greek debt buyback at a sharp discount, lowering the interest rate and lengthening terms on the loans and the ECB foregoing profits on its Greek bondholdings – have been agreed to.