The Anatomy of the U.S. Deficit Deal

The Last-minute $3 trillion deal is paving way for deeper political and economic polarization in America.

Since mid-May, when the U.S. debt hit $14.3 trillion debt ceiling, the nation has lived on borrowed time. During the past three months, tension and friction has escalated dramatically as Washington has debated an array of deficit-plans before the August 2 deadline.

On Sunday evening – only minutes before the opening of the critical Asian markets – the lawmakers closed a $3 trillion deal. If successful, this deal will raise the U.S. debt limit by $1 trillion and avoid a potentially chaotic default. However, it is less likely to deter the downgrading of U.S. credit rating – after August 2, or in the near-term future.

In fact, the fragile, two-stage deal reflects an economic and political stalemate that is even worse than has been acknowledged.

How Obama’s Bipartisan Commission failed

Since spring, Capitol Hill has debated a number of debt-reduction plans. In November 2010, the Republican Budget Committee Chairman Peter Domenici and former Clinton budget director Alice Rivlin produced a $6 trillion deficit-reduction plan, which was evenly split between budget cuts and revenue increases.

In other words, every dollar in budget cuts was matched by a dollar in increased revenues. The former were designed for the “cut only” Republican Tea Party groups; the latter for the “spend only” liberal Democrats.

However, it was overshadowed by another plan by Obama’s National Commission on Fiscal Responsibility and Reform, led by the Democratic Erskine Bowles and Republican Alan Simpson. Their plan sought to reduce deficit spending by about $4 trillion over the coming decade.

The Bowles and Simpson plan promised to overhaul the tax code, eliminate or reduce the $1 trillion a year in popular tax breaks for individuals and corporations. It hoped to use the revenues mostly to slash income tax rates but also to reduce deficits. In order to make Social Security solvent for 75 years, it planned to raise payroll taxes for the affluent and reduce future benefits, including by slowly raising the retirement age for full benefits to 69 from 67 by 2075.

Some two decades ago, Bowles-Simpson plan would have passed, after backroom revisions and modifications. In early December 2010, it failed a vote with 11 of 18 votes in favor. It would have needed a supermajority of 14 votes needed to formally endorse the blueprint. It is those three missing votes that paved the way to the reckless stalemate chaos.

What is even more important, the Bowles-Simpson plan moved the goal posts of the future deficit-plans, calling for $2 in budget cuts for every $1 in revenue increases. Instead of resulting in a bipartisan détente, this plan encouraged the Tea Party groups to demand even more spending cuts and the infuriated liberal Democrats to insist on tax increases.

How Washington’s Bipartisan Efforts Failed

After the eclipse of the Bowles-Simpson and Domenici-Rivlin plans, a small group of highly-regarded Republican and Democratic leaders began to work on a bipartisan deal. It got close to a deal, fell apart and, after a while, got back together. In July 2011, this so-called “Gang of Six” proposed a bipartisan $3.7 trillion plan to the U.S. debt ceiling crisis. The compromise was closely patterned on the recommendations of the Bowles-Simpson plan: $2.5 in budget cuts for every $1.20 in tax revenue increases.

Praised by President Barack Obama, it was initially welcomed as the long-waited manna from heaven in the White House and among mainstream Republicans and Democrats. But it soon met with criticism from Republican conservative groups for being “heavy on tax hikes and promises of spending cuts, but devoid of details on how to make the sweeping transformative changes needed to solve our debt and spending crises,” as the Heritage Foundation put it.

By mid-July, still another bipartisan plan emerged. It was designed as a basically a scaled-down $1.5 trillion option by Senate’s leaders, the Republican Mitch McConnell, and the Democratic Harry Reid. In other words, it proposed $1.50 in spending cuts for $0 tax increases. To Tea Party groups, it was too little too late; to liberal Democrats, it was just another concession to conservative Republicans.

By then, the Tea Party groups and their sympathizers in the House of Representatives were calling for far deeper spending cuts, a federal spending cap and a balanced budget amendment. The large $5.5 trillion “Cut, Cap and Balance” bill was based exclusively on spending cuts, with no tax increases. It proposed deep cuts in Medicare, Medicaid, and food stamps, and even deeper cuts in Supplemental Security Income for the elderly and disabled poor by the end of the decade.

Ideologically, the “Cut, Cap and Balance” bill reflected the longstanding efforts of Grover Norquist’s taxpayer advocacy groups to push the Republican Party toward a rigid position of opposing any tax increase, of any kind, at any time. “I don’t want to abolish government,” Norquist has said. “I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub.”

The bill did a great job not just mobilizing the Tea Party groups, but also by enraging the liberal Democrats. The resulting stalemate virtually ensured that no compromise would be possible until the last moment; that any compromise would be strong enough to achieve a new debt ceiling; but too weak to prevent the downgrading of U.S. credit rating – either right after August 2 or soon thereafter.

The Compromise That Is No Compromise

With barely 11 days left to the August 2 deadline, President Obama and Speaker John A. Boehner were closing in on a budget package calling for as much as $3 trillion in savings over the next 10 years. But the proposed Grand Deal collapsed on July 22.

Half a week later, Boehner, and the Senate majority leader, Harry Reid, offered rival plans to raise the federal debt limit. Boehner called for a total $3 trillion in spending cuts, while raising the debt ceiling by $2.6 trillion in two phases, with the second one before the 2012 election. The proposals included no tax cuts. Endorsed by President Obama, Reid’s plan would have reduced the deficit by $2.7 trillion and raised the debt ceiling until after the 2012 election. The plan included savings that Republican leaders have supported. However, it did not include tax increases.

Both plans were smaller than the $4 trillion deficit-reduction package President Obama had advocated earlier – but similar in size to the McConnell-Reid plans, which had been shot down. After struggles with his Republican rebels, a weak version of the initial Boehner proposal passed in the House, but was killed in the Senate.

Despite the public drama, the outcome was known well in advance. What was more important was the simple fact that, by now, both Republican and Democratic leaders were finally in a position to hammer the final deal; and this deal had to be in package before the opening of the Asian markets. The last thing Congress needed at this point was market turmoil in Asia that could potentially spread to Europe and the United States in early August.

As a result, the final $3 trillion deal was sold to the American public by President Obama in breaking news some 15 minutes before 9 pm (EST).

If successful, the deal will avoid a U.S. default. But it is unlikely to avert the downgrading of U.S. credit rating in the near future – which, in turn, could have an adverse impact on U.S. recovery.

In order to sustain its triple-A rating, Washington should have agreed on a credible long-term fiscal adjustment (read: a $4 trillion, one-stage deal). In the absence of a credible, long-term fiscal adjustment and adequate containment of health care costs, the postwar trust in in the U.S. political leadership and America’s economic prospects has now been shaken, perhaps irreversibly.

Deep Gap between Washington and America

If there is a single common denominator to this long-winding debate, it is the gradual and steady shift away from the pressing issues of U.S. secular stagnation and unemployment to the issues of deficit cutting and austerity. In the foreseeable future, this shift will deepen the already deep economic polarization in America.

Today, income inequality in the United States is already about the same or higher as in Iran, Venezuela and Nicaragua – and some 30-40 percent higher than in Europe in average, as measured by the Gini coefficient.

Politically, the debate has only contributed to the polarization between and among the two dominant parties. There is a deepening gap between traditional Republicans and the ultra-conservatives of the Tea Party group and other fringe elements. There is also a deepening gap between middle-of-the-road Democrats and center-to-left liberal Democrats.

America’s 2011 deficit debate has been less about solutions to economic realities than about positioning to the impending 2012 election.

Washington’s shift from the issues of secular stagnation and unemployment to deficit-cutting and austerity does not reflect the views and preferences of ordinary Americans. Only 7% of Americans believe that budget deficit/national debt is the most important problem facing America today, according to the recent CBS News/New York Times poll. In contrast, some 53% of Americans believe that economy/jobs are the nation’s priority today.

In fact, a whopping 79% of Americans are dissatisfied with the direction of the nation, according to Pew Research. It is only seldom in the U.S. history that the gap between Washington and the Main Street has been as deep. Concurrently, the revised GDP figures indicate that the U.S. economy is barely breathing, growing only 1.3% in the second quarter (and barely 0.4% in the first quarter).

Washington’s deficit deal is a compromise of compromises. Politically, it does not reflect a bipartisan consensus but deepening polarization that will make such consensus even more elusive in the foreseeable future. Economically, it will do nothing to resolve the pressing issues of secular stagnation and unemployment in America; over time, it is likely to prolong both.