Hamish McRae: Time for US to deal with surging deficit

So now the race is to the cliff. The financial markets have reacted as predicted to the United States' election result, with an Obama victory indeed proving bad for equities and good for bonds.

But there are other longer-term factors at work that reinforce these moves, in particular the return of jitters about the health of the European economy and a focus on the overriding issue in the world of finance for the next couple of months on how the US is going to tackle its fiscal deficit.

Worries about Europe are behind the renewed flight to the safe havens of US, German and UK debt, while the general weakness in equity markets is related in part to fears that the US might botch its handling of its fiscal position and push the economy back into recession.

There may well be further weakness in equity markets ahead, but I don't feel we should be too startled by that. The US market has recovered strongly from its collapse in 2007 and the spring of 2008, rather more strongly than it did following the similar collapse in 1973-74. Chris Watkins of Longview Economics has been warning that a shading back of share prices would be consistent with past experience. Shares, you could say, had got a bit ahead of themselves.

On the Europe issue, there is not much new to be said, except perhaps to note that the latest data on the French economy have been particularly worrying and that the damage to Greek society has become quite devastating: pensions being cut, yet more taxes being loaded on to the middle class, government payments being delayed and so on. The Greek exit from the euro has clearly been postponed into next year. But this is all known; what is unknown is what America will do next.

A visit to Washington just before the election left me no clearer and post-election the US commentators seem as confused as everyone else. But I suspect this is going to be one of those stories where, outside the US at least, the detail matters less than the big numbers.

That the deficit will be cut is not in doubt. It is not sustainable for a country, even one with the borrowing and printing capacity of the US, to continue spending $5 for every $3 it collects in tax. It is not sustainable partly because at some stage the rest of the world will not tolerate it.

We have had similar situations before. Bill Clinton inherited a serious deficit but managed to push the federal budget back into surplus, a great legacy for George W. Bush, which was then sadly squandered.

The explosion of federal debt appears just as unsustainable as the surge in house prices did four years ago, for whenever financial numbers move to extreme levels, common sense tells us that they will eventually correct themselves.

But how? Ignore the statements by Congressional leaders, for in the post-election shock they should not be taken too seriously. Instead, apply common sense. There are four broad possible outcomes. Outcome one is that Congress remains deadlocked and the country does indeed go over the cliff. There would be the sudden tightening of policy that would on paper be equivalent to something like 4 per cent of GDP. The shock effect would be considerable, particularly if Congress refused to agree to an increase in the debt ceiling and the government was unable to meet payroll. But I would expect after a few weeks, something would be cobbled together and though you are not really supposed to say this, a shock of this nature might be rather refreshing and force real change. The chances: perhaps 20 per cent.

Outcome two is that there will be a deal, with the emphasis more on spending cuts than tax increases. This is the most likely outcome, say a 40 per cent chance, but will be difficult to administer because the structure of US government spending is rigid: there are a lot of things that cannot be cut. In macroeconomic terms a gradual squeeze is probably the best outcome, but it will be difficult to do well.

Outcome three would be some cuts but with more emphasis on a radical reform of the tax system, which would increase revenues by simplifying taxes, getting rid of all the anomalies and enabling nominal tax rates over time to come down. This would be the best solution but requires a determined and engaged President and a more co-operative Congress. President Barack Obama would have to be much more persuasive. Chances: 20 per cent.

Finally there is outcome four, which would be modest changes to the tax system and spending patterns, with the real problems postponed. This would be the worst outcome of all, for it would undermine confidence not only of foreign savers but also of the US business community. I am afraid there must be a 20 per cent chance of this happening. If it does, then the dollar and US government securities stop becoming the safe haven, which would be bad news indeed for us all.

- Independent