By James Politi
Published: January 13 2011 22:15 | Last updated: January 13 2011 22:15

It was the most startling of warnings. If the US does not get its finances in order “we will have a European situation on our hands, and possibly worse”, claimed Paul Ryan, the new Republican chairman of the House of Representatives budget committee.

The consequences of not tackling the country’s mounting debt burden would be dire, he last week told an audience of leading budget experts and economists at a gathering in Washington. “We will have the riots in the streets, we will have the defaults, we will have all of those ugliness problems,” he said, referring to “French kids lobbing Molotov cocktails at cars, burning down schools because the retirement age will be moved from 60 to 62”.

As it stands today, the US borrows about 40 cents of every dollar it spends. Curbing the budget deficit has been the stated mission of Mr Ryan, a rising Republican star, for several years. But such calls for action have multiplied in Washington in recent months, igniting what some say is the fiercest debate over fiscal and budgetary policy in decades.

The risks are big. If the government rushes into austerity, cutting too much and too quickly, it could stunt economic recovery. But if the political system cannot forge some kind of consensus on steps to restore US deficits to sustainable levels, the danger is potentially even greater: a sovereign debt crisis in the world’s largest economy.

“It’s a weak period for the economy, so I don’t think you want to do serious deficit reduction anyway, but we are playing a dangerous game and we will start to pay a price for fiscal irresponsibility,” says Ethan Harris at Bank of America Merrill Lynch.

The big fear is that if no action is taken, investors might eventually punish the US for its fiscal laxity. That would raise borrowing costs for businesses and consumers, force severe austerity measures and risk social unrest. Not only America’s triple-A credit rating could be threatened; some point to consequences in foreign affairs and defence as well. Mike Mullen, chairman of the joint chiefs of staff, last year warned that the debt pile could limit the flexibility of the US in funding its military – in his eyes the “most significant threat to our national security”.

So far, capital markets have not reacted much to the dismal long-term outlook. The 10-year Treasury yield, for instance, has been trading this week well below 3.4 per cent, close to historical lows although it has risen in recent months. Still, a growing number of voices are calling for a deal to address America’s strained public finances, even if it means tackling programmes such as retirement benefits and healthcare for the elderly that have long been protected.

Yet whether this anti-deficit rhetoric translates into a meaningful turn towards austerity in the coming months – and leading into the 2012 presidential election – is much in doubt, for two main reasons: severe political divisions and the continuing fragility of the economic recovery.

“It’s not urgent but at some point it’s going to become more urgent,” says Phillip Swagel, who was a senior economic official in the George W. Bush administration. “Clearly the markets don’t think we’re Argentina, but we should send them a signal that they are right, that we will address the issue.”

A deal extending Bush-era tax cuts and unemployment benefits in December failed to send that message, adding $858bn to long-term deficits without any commitment to reductions in the future, even though supporters argue that if the measures boost growth, America’s budgetary position will improve too.

But more big tests of America’s commitment to fiscal discipline are looming. On January 25, President Barack Obama will lay out his legislative priorities for 2011 in his State of the Union address to Congress, and measures to reduce long-term deficits are expected to be on the agenda.

Some policies have already been flagged. In December, the president announced a two-year freeze on pay for civilian government workers, a nod to the need for budget cutting to begin at some point. The Pentagon has also been trying to get ahead of the game: last week it announced that it would trim its annual budgets of more than $500bn by a combined $78bn over the next five years compared with earlier projections.

These measures will be incorporated into the White House’s proposed annual budget, to be presented in mid-February. Other steps could also be included, such as possible additional plans to cut discretionary spending across government agencies, start tackling social security reform and set a framework for tax reform.

Much attention will be paid to both the scope of these proposals and how specific they are, and to signs of the seriousness of the administration’s commitment to deficit reduction.

Mr Obama’s new economic team certainly bodes well for fiscal hawks, including as it does Jack Lew as budget director and Gene Sperling as head of the National Economic Council. The two are back in the same roles they held under Bill Clinton in the 1990s, when the US reduced its deficit through negotiations between a Democratic White House and a Republican Congress. Mr Clinton left office with a budget surplus.

Few expect the administration to take the aggressive approach sought by some prominent Democrats such as John Podesta of the Center for American Progress, a think-tank with close ties to the Obama White House. This would involve cuts to large programmes such as Social Security and Medicare, followed swiftly by a move towards tax reform. But it is unlikely to happen, because it could expose the administration to a barrage of attacks from both its Democratic base and from Republicans.

Nevertheless, Mr Lew maintains that the administration’s resolve on deficit reduction is clear. “We need to have a bipartisan effort, which will address the serious fiscal challenges before us while at the same time promoting an agenda that will build the foundation of the American economy in the future, which to us means continuing to invest in education and innovation even while we make reductions in other places,” he says.

But Republicans, who gained control of the House of Representatives in elections last November, partly on a message of fiscal rectitude and opposition to government spending, have other things in mind. They envisage spending cuts on a much larger scale than what is palatable to the White House or many congressional Democrats – and could resist any attempt by the administration to press ahead with new stimulus measures.

Many Republicans have shown little willingness to consider tax increases as part of any deficit reduction package – which many economists believe to be an essential component of a deal. The result could easily be gridlock, with both parties and the White House trading accusations, and investors and businesses growing increasingly nervous about America’s ability to deal with the debt problem.

Meanwhile, a deadline that will force the two parties to engage – and probably battle – on fiscal issues is close. Any time between March 31 and May 16, the Treasury estimates, US debt will hit its congressionally mandated limit of nearly $14,300bn. If the administration and Capitol Hill cannot agree on a deal to raise that threshold, the US would have to shut down the government and default on its international debt obligations – potentially triggering the debt crisis that for the moment seems so distant.

Many Republicans have insisted that a higher debt ceiling should be tied to their aggressive spending cut targets, setting the stage for a big political showdown as the date approaches.

The administration does not believe the debt limit should be used as a bargaining chip to extract concessions. “Our view is a clean debt bill is the only responsible thing to advocate – and we’re clearly going to have to engage in Congress on this,” says Mr Lew. “We have no alternative but to raise the debt ceiling and it would be irresponsible to use the need to raise the debt limit as a way to force a crisis that could undermine the US economy and its standing in the world very severely.”

Lawmakers as well as analysts expect in general that over the next few months a limited agreement – possibly on its own, and possibly involving the enactment of some deficit reduction measures proposed by the administration plus some new ones – will be reached. But while such an accord could placate investors in US debt for some time, it will probably only delay America’s reckoning with its unsustainable public finances rather than correct the course.

America’s budget deficit in the year to last September amounted to about $1,300bn – the second highest on record. Over the next several years, as the economic recovery advances and the impact of emergency spending measures taken during the recession start to wane, the country’s deficits are expected to shrink naturally.

But the relief will be temporary: because of the retirement of the baby-boomer generation, which starts in earnest this year, the cost of government healthcare and pension programmes is projected to soar. According to a report issued last month by an 18-member bipartisan commission on fiscal responsibility, by 2025 tax revenues will be sufficient to finance only interest payments – which are projected to soar from their current $200bn a year to more than $1,000bn – and entitlement programmes, with no room for anything else.

“Every other federal government activity – from national defence and homeland security to transportation and energy – will have to be paid for with borrowed money,” it warns. By 2035, rising debt could reduce gross domestic product per capita by as much as 15 per cent. That would imply a harsh reduction in Americans’ standard of living.

This gloomy picture is what could eventually cause a crisis in international capital markets. It is also what drove the commission, led by Erskine Bowles, former White House chief of staff under Mr Clinton, and Alan Simpson, former Republican senator from Wyoming, to attempt what had rarely been tried before in Washington: to craft a detailed template to solve the country’s budget woes, offering Americans and their lawmakers a concrete glimpse of what it would take to correct the problem.

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