Nobody should be surprised that Wall Street hit new records this week. After all, the U.S. has just witnessed the end of a sensational hostage crisis that was threatening national security and undermining economic confidence — and even more sensationally, this was the second such crisis in two months.

John Boehner was held hostage by Republican hardliners until last Thursday, when the U.S. Congress voted to continue pumping money into the U.S. government. The fiscal militants forced Boehner to endanger the U.S. economy with threats of a Treasury default. Boehner reluctantly paid this rhetorical ransom in order to preserve the appearance of party unity and therefore his own credibility as a political leader.

Now consider events a month earlier on the other side of Washington. Until September 18, when the Federal Reserve voted to continue pumping money into the U.S. bond market, Ben Bernanke was arguably held hostage by the Fed’s hardliners. The monetary militants forced Bernanke to endanger the U.S. economic recovery with threats of a premature end to Quantitative Easing. Bernanke reluctantly paid this rhetorical ransom in order to preserve the appearance of institutional unity and therefore his own credibility as an economic leader.

The fact that both these hostage crises were resolved without any bloodshed or major economic damage, was naturally cause for financial celebration. But what happens next will depend on an interaction between Boehner, Bernanke and President Obama that has not yet been widely analyzed.

Let us begin with politics and the Boehner-Obama relationship. Both Republican and Democratic leaders now badly want to avert the next phase of automatic spending sequestration that is due to start in mid-January in the absence of a budget deal. Democrats want higher public spending as a matter of principle, while Republicans are under huge pressure from defense contractors to avert the next round of sequestration, which will bear much more heavily on defense spending than the cuts last year. Moreover, neither side has anything left to gain by threatening a budget breakdown — and both have much to lose if they are held responsible for extended gridlock.

Most importantly, a deal is now on the table that would be acceptable and even attractive to both sides: The Republicans could agree to lift the sequester and slightly raise government spending in the short-term, in exchange for the Democrats agreeing to small long-term economies in Social Security and Medicare.

To clinch such a deal would take only one concession from President Obama: all the President has to do is drop his insistence on raising taxes. Obama may see ideological appeal in higher taxes, but in terms of practical politics, conceding to the Republicans on this issue could free his presidency from the misery of endless budget tussles and would be much easier now than at any time in the past five years.

The main reason why declaring a truce on taxes would be easy for Obama today is that he no longer needs extra revenues to stabilize the U.S. budget. Steady improvement in the U.S. economy, combined with the rate tax hikes already introduced in the January 2013 fiscal cliff deal, are sufficient to put the government-debt-to-GDP ratio on a declining path at least until the end of the decade. A second reason for Obama to drop his demand for tax hikes should be the recognition that this is the totemic budgetary issue on which the Republicans could not possibly compromise, just as Obama himself could not compromise on delaying Obamacare.

If the White House abandoned its demands for higher taxes, a comprehensive fiscal agreement could well be reached by the deadline of December 15 set in last week’s Congressional vote. And if no comprehensive budget deal could be reached by the December deadline, what would happen in Congress? Now that Boehner is freed from the Tea Party’s fiscal militants and able to exercise his own judgement, it seems almost certain that he would want to secure his reputation as a responsible politician by allowing a simple Congressional vote to implement the January sequester spending cuts, continue funding the government and extend the debt limit beyond the election of November 2014. Since the January spending cuts would amount to only around 0.5 percent GDP, the resulting headwind to economic growth next year would be much less severe than the fiscal tightening of 2.5 per cent of GDP in 2013.

How would all this affect monetary policy and financial markets? Now that Bernanke is freed from the Fed’s monetary militants and able to exercise his own judgement, it seems very likely that he would want to secure his reputation as a responsible central banker by starting to normalize U.S. monetary policy before his retirement at the end of January. If the Congress agrees a budget deal by December 15, Bernanke could well take advantage of the resulting upsurge in economic confidence to start tapering at the Fed meeting on December 19. Failing that, and assuming a simple continuation vote in December to implement the sequester, fund the government and extend the debt ceiling, Bernanke might still want to announce a tapering at his last Fed meeting as Chairman on January 29. Either way, the many investors who believe that tapering has been indefinitely delayed by last week’s political shenanigans in Washington are likely to be proved wrong.


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.