The U.S. budget battle was always likely to end in a Republican defeat and a rout for Tea Party firebrands; but the outcome has turned out to be even more dramatic: an unconditional surrender, instead of the negotiated ceasefire suggested here two weeks ago. Trying to spot historic turning points in real time is always risky, but the scale of this debacle suggests that U.S. politics and economic policy really will be transformed in at least four important ways.

Firstly, the shift in the balance of power between Obama and the Republicans since last November, described here, has been spectacularly confirmed. It is too early to guess whether the GOP’s slumping popularity will give the Democrats a chance to regain control of the House of Representatives next November. The Democrats would be very likely to achieve this if they could hold on to their present lead of 5.5 percentage points in the Real Clear Politics average of Congressional vote polling, since this would represent a swing in favor of the Democrats of 4 percent, which should suffice to win the extra 17 seats they would need to win control.

Conventional wisdom in Washington contends that a Democratic win next year is almost impossible because of a historic tendency of presidential parties to lose votes in midterm elections, but this history has little statistical significance, and is counterbalanced by the voting figures from the three occasions since 1945 when parties that lost the popular vote kept control of the House. In all these cases the majority party in the House only lost the popular vote by tiny margins — in 1952, by 0.5 percent, in 1996 by 0.7 percent and in 2012 by 1.2 percent. So an election in which the Republicans lost the popular vote by 5.5 percent, as indicated by recent polling, but kept control would create a totally unprecedented situation. In any case, speculation about next year’s election is pointless since the polls are likely to shift abruptly — one way or the other and for reasons we cannot even imagine today. What is clear, however, is that the Republicans face deep unpopularity in the short-term and this will transform the outlook for economic policy in the next few months.

Republicans now lack the confidence, the unity and the public support to risk another major battle over budgets in December or debt limits in February. An army in flight cannot suddenly turn around and mount a successful counter-attack. Regrouping a routed army takes months, if not years. The idea that Republicans could threaten another government shutdown or default before the December and February deadlines is therefore an illusion. Since everybody who matters in Washington now understands this, the approaching budget and debt negotiations should prove surprisingly consensual and calm.

This leads to the second historic transformation. The outlines of a possible long-term U.S. budget deal are now fairly clear. The White House is now in a position to dictate the broad terms of a budgetary truce, but that does not make the Republicans powerless. President Obama has a strong interest in agreeing to a long-term fiscal deal and refocusing his presidency on other issues. He is therefore likely to offer some significant concessions to settle the budget once and for all.

The president has already indicated that he might be willing to trade some long-term economies in Social Security and Medicare for a Republican agreement to lift short-term sequestration spending cuts. Such a deal, in addition to reducing long-term fiscal pressures, would be doubly attractive to Obama. Lifting sequestration would provide a neutral or slightly expansionary fiscal policy over the next two years, thus strengthening recovery. Meanwhile, the Republicans’ vociferous insistence on Social Security and Medicare cuts would relieve Democrats of any blame for these fiscally necessary, but highly unpopular reforms.

Apart from discussing Social Security and Medicare reforms, to which Obama has already agreed, the Democrats need to make only one more concession to facilitate a bipartisan deal: they must abandon their insistence on higher taxes. While conventional wisdom maintains that this is the one concession Obama will never make, it would actually be surprisingly easy because of changing economic conditions. Recent revisions to budget forecasts imply that the U.S. government no longer needs additional revenues to control its deficits. As Larry Summers has pointed out, the federal deficit will narrow to just 2 percent of GDP by 2015, even without further fiscal action. Beyond that an increase of just 0.2 percentage points in the economy’s structural growth rate “would entirely eliminate the projected long-term budget gap.” Obama and the Republicans could therefore reconcile their budgetary objectives by agreeing on tax reforms to boost the economy’s long-term structural growth rate, instead of seeking to squeeze more revenues out of the present dysfunctional tax structure. By focusing on “dynamic” accounting that takes account of the revenue gains from higher expected growth rates, tax reform could easily become a winning proposition for both Republicans and Democrats.

Thirdly, a fiscally neutral or expansionary long-term budget deal should ensure an acceleration of U.S. economic growth. GDP growth, excluding the effect of public spending cuts, has been running at a steady 3.5 percent since late 2009. If the fiscal drag created by sequestration could be eliminated by a long-term budget deal, total GDP growth of 3.5 percent should be achievable from early next year onwards.

A final effect of the budget deal should be to lift the cloud of political dysfunction and monetary uncertainty that currently hangs over the dollar. The budget battle paradoxically helped the U.S. economy and financial markets by delaying Fed tapering until at least December. But now that the battle is over, tapering should begin in December or early next year. And once the Fed starts to taper, the process will be clearer and more decisive, since fears of unplanned fiscal tightening will be removed by whatever budget deal is reached. Greater clarity in both monetary and fiscal policy should restore some confidence in the dollar, improve business sentiment and perhaps drive up prices on Wall Street.

In short, one of worst political blunders in modern U.S. history is likely to be remembered as good news.


Anatole Kaletsky is an award-winning journalist and financial economist who has written since 1976 for The Economist, the Financial Times and The Times of London before joining Reuters.