House budget committee chairman Paul Ryan, left, talks with U.S. Rep. Mike Pence prior to a Republican conference meeting on Monday. Chip Somodevilla/Getty ImagesChip Somodevilla/Getty Images
The political winner in Washington's debt showdown is still uncertain, but the victor of another clash with economic repercussions is now clear: Austerity has beaten stimulus, hands down.
Stock and bond markets wavered Monday as investors watched the standoff over the looming Aug. 2 deadline to raise the country's $14.3-trillion (U.S.) debt ceiling.
Senate Leader Harry Reid and House Leader John Boehner unveiled competing proposals to raise the debt limit. Both plans feature major spending cuts to reduce the U.S. budget deficit by more than $2-trillion over a decade.
And neither plan includes stimulus measures to stoke an economy that has lost so much momentum this year that it is no longer growing fast enough to lower the unemployment rate.
The White House threw its support behind Mr. Reid, suggesting President Barack Obama is giving up trying to use the debate over the debt ceiling to win support for further stimulus measures, such as a payroll tax cut and an infrastructure spending program.
That means government spending, which buoyed the world's largest economy for much of the past two years, is on track to become a drag on the economy just as the recovery is starting to sputter.
Mr. Reid's proposal would shrink the U.S. budget shortfall by $2.7-trillion, roughly equivalent to the additional borrowing authority the Treasury Department would be given to fund the government's operations without interruption through the 2012 presidential election. That's far short of the "grand bargain" that Mr. Obama and Mr. Boehner flirted with on occasion over the past few weeks. To forestall the risks associated with an unprecedented default, the Democrats, who control the White House and the Senate, are abandoning their attempts to get the Republican-controlled House of Representatives to accept tax increases.
Democrats are also abandoning stimulus at a moment when some economists say the U.S. economy could badly use some. The bet is that businesses will react favourably and increase investment amid evidence that U.S. politicians are getting serious about a debt that has expanded to 70 per cent of gross domestic product from 36 per cent of GDP in 2007. But if that investment remains on the sidelines, it will create a situation where private spending remains weak while government spending is contracting.
"From an economic perspective, the debate has made very little sense," Robert Shapiro, chairman of Washington-based economics consultancy Sonecon LLC and an undersecretary at the Commerce Department during Bill Clinton's presidency. "We need more stimulus in this economy."
A government report set for release on Friday likely will show the U.S. economy grew at an annual rate of about 2 per cent in the second quarter, according to the consensus estimate of Wall Street economists. That's way too slow to lower the unemployment rate, which has risen for three consecutive months and touched 9.2 per cent in June. To reverse the jobless trend, the economy must grow at a pace of between 3 per cent and 4 per cent, economists say.
To be sure, policy makers in the U.S. are trying to strike an extremely delicate balance.
The International Monetary Fund's executive board said Monday that "placing public debt on a sustainable path is critical to the stability of the U.S. economy, with positive spillovers to other countries."
Yet, the IMF's leaders cautioned against cutting spending with too much haste. They said budget consolidation should begin next year to ensure "credibility," but that it would be enough to do so within a longer term program that would stabilize the increase of the U.S. debt-to-GDP ratio over the medium term.
"Directors called for a cautious approach to unwinding macroeconomic support," the IMF said in a statement on the board's annual assessment of the U.S. economy. "The pace of deficit reduction in the short run could be more attuned to cyclical conditions."
The IMF's 24-member executive board also said it was "critical" that U.S. politicians find a compromise to raise the debt ceiling, a legislative speed bump that for decades was lifted in a routine manner. This time, the Republicans who took control of the House of Representatives in November's mid-term elections are using the vote to insist on dramatic spending cuts. The Treasury says it will run out of accounting tricks to pay the U.S. government's bills on Aug. 2. Failure to renew the Treasury's borrowing authority could result in a default and the loss of the U.S. top-notch credit rating.
While there are signs of skittishness in financial markets, investors so far are maintaining their cool over the prospect of a U.S. default. The yield on 10-year Treasury debt climbed a little Monday, but only to about 3 per cent, which is low by historical standards. The U.S. dollar was little changed against a basket of other major currencies. Financial assets that insure against default suggested that investors thought there was a 0.6 per cent chance that the U.S. would miss a debt payment.
One reason U.S. bond yields, which have an inverse relationship to the security's price, are low is that investors value them as a safe haven during economic weakness. The U.S.'s debt is a worry, but so is the prospect of an entrenched period of high unemployment and stagnant demand.
"I'm worried we're in for a long period of slow growth," said Phillip Swagel, an economics professor at the University of Maryland and former chief economist at the Treasury Department under George W. Bush. "I'm not sure stimulus is needed, but you could make a good argument for it."