Stephen Boyle, Head of Group Economics at RBS

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During Bill Clinton’s first run for the presidency in 1992, a wall at his headquarters in Little Rock, Arkansas bore the legend ‘The economy, stupid!’. It was campaign manager James Carville’s daily reminder that arguments about the economy would win or lose the White House.

With the US limping from one bout of quantitative easing to another amid weak house prices, high unemployment and lacklustre confidence, the central question in the current campaign will be how to get the economy heading in the right direction again.

Looming over 2012 is the spectre of the nation’s public finances. We’re all too familiar with the woes of countries in the euro area as they struggle to manage debt burdens that look simply unsustainable. Those of us in the UK know that our government’s principal focus is on getting to grips with the deficit and debt.

Yet according to the International Monetary Fund, only in some peripheral euro area nations and Japan will government debt as a proportion of national income be higher than in the US in 2012. Without action, US debt will reach 113 per cent of its income come the 2016 election1, a level that would almost certainly impair the nation’s growth prospects very substantially.

US public finances can be fixed and that can go hand-in-hand with restoring growth today. Although its debts are high, the US is in no danger of defaulting any time soon. It pays very low interest rates and has little trouble convincing investors to trust in Uncle Sam, despite the ratings downgrade last summer.

The real challenge lies a few years down the line when regiments of baby boomers start to draw public pensions and rely on publicly-funded healthcare. If the US sticks broadly to its spending plans, the Congressional Budget Office (CBO) reckons that by the mid-2030s, the country will be spending USD16 from every USD100 of national income on healthcare and pensions compared with USD10 today.

The positive message to take from this is that there is ample time to fix the problem. Reducing the deficit does not have to start today. Rather, the incoming administration and Congress will have to make a credible commitment to cutting spending and raising taxes over the medium-term.

That won’t be easy. For most Democrats, cuts to spending on pensions and healthcare are non-negotiable, as are tax rises and defence budget to most Republicans.

That leaves only a fraction of spending, on items like education and transport, to bear the full weight of mending the public finances. This is not a tenable position. Both sides will have to sacrifice some sacred cows.

Making a credible commitment now to fiscal repair later could give the US the ‘Get Out of Jail Free’ card they need to deal with two immediate problems.

First, weak growth and joblessness. It is little reported, but the US has been pursuing fiscal austerity since early in the current administration. Its deficit as a share of national income peaked three years ago and it is still heading south today. State and local governments have cut spending. Since the third quarter of 2009, US public spending has fallen from USD2.614 trillion2, constituting 20.5 per cent of GDP, to USD2.479 trillion or 18.3 per cent of GDP by the end of the second quarter this year. With interest rates effectively at zero and the economy performing poorly, the US needs a fiscal boost.

Second, if the US applies all of the laws on its statute books, 1 January 2013 will see the Bush Tax Cuts expire as spending cuts agreed as part of the 2011 debt ceiling compact are implemented. This would lead to a deep recession. The CBO predicts that although these would reduce the deficit from 7.3 per cent of GDP to 4 per cent, the US economy would contract by 0.5 per cent in 2013.

That does not have to happen. I expect that between the election on 6 November and the end of the year, such a severe outcome will be averted. But recent history suggests that reaching a solution will see a huge amount of midnight oil being burned.

Solving these two problems means winning permission from investors to loosen the reins today by convincing them that the medium-term problems have been addressed. Will the US do it?

 

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October 2012