US Debt Deal: How Washington Lost the Plot

Politicians and the media are obsessing on debt, deficit and cuts, but the real story is a stalled economy and rising unemployment

President Obama and the Republicans in Congress have finally worked out a deal over the debt ceiling. It appears as though the Republicans got most of what they wanted: big cuts to domestic spending and no tax increases.

On the plus side, social security and Medicaid appear to be largely intact, although the deal commits Congress to set up another one of those dreadful "bipartisan" commissions, and some cuts to Medicare are on the table. The main qualification for being chosen as a member or staffer for this commission will be that you were too ignorant of the economy to notice the $8tn housing bubble whose collapse brought on the current crisis. Fortunately, Washington has no shortage of policy wonks who fit this description.

While many in the media and around the country had been panicking over the possibility that no deal would be reached and the government would actually default on its debt, those who understand American politics knew that this is not a concern. The reason is that Wall Street is on the frontline in this battle.

If there were a default on US debt so that it could no longer be held on bank books as being a riskless asset, most of the major banks would likely be insolvent. It would not be just US debt that must written down, but also debt implicitly guaranteed by the government, such as mortgage-backed securities issued by Fannie Mae and Freddie Mac, as well as a wide range of other assets held by the banks.

The loss of value of on a wide range of assets could easily wipe out the capital of the Wall Street banks, putting them on the road to Lehman land. Since JP Morgan, Citigroup and the rest have enormous power in Congress, it was a safe bet that they would force their allies to find a way to keep them in business. Therefore, there was never any reason to worry about the default story.

What we should be worrying about is all the news that Washington has ignored while it was doing the debt ceiling shuffle. Most importantly, the economy has almost stopped growing and unemployment is again on the rise.

On Friday, the commerce department released data showing the economy grew just 1.3% in the second quarter. Even worse, it revised down the first quarter growth number from 1.9% to just 0.3%. This means that the economy was growing at just a 0.8% annual rate over the first half of 2011. This is well below the 2.5% pace that is necessary just to keep unemployment from rising.

Of course, unemployment has been rising, with the June figure hitting 9.2%. That is up from a post-recession low of 8.8% in March. The unemployment rate does not give the whole story, since many of people have lost hope of finding a job and given up looking for work altogether. The employment to population ratio (EPOP) - the percentage of the population with jobs - has fallen back almost to its low point for the downturn. The EPOP for African Americans has hit new lows in each of the last three months.

The revisions also provided other interesting pieces of information. For example, corporate profits were revised sharply higher for both 2009 and 2010. The share of profits in corporate sector output hit a new record high, more than a full percentage point above its previous peak. Finance was the biggest winner within the corporate sector, accounting for 31.7% of corporate profits, also a record high.

In short, we now have an economy that is stuck in the doldrums. It is operating well below its potential level of output. Furthermore, instead of catching up, it appears to be falling further behind. We are seeing a growth rate far below the economy's potential, when we should be seeing growth that is far above potential. And the Wall Street guys are fat and happy.

There was another interesting item in the revised data. It showed that the economy was plunging even more rapidly than we had previously recognised in the two quarters following the collapse of Lehman. Yet, the plunge stopped in the second quarter of 2009 - just as the stimulus came on line. This was followed by respectable growth over the next four quarters. Growth then weakened again as the impact of the stimulus began to fade at the end of 2010 and the start of this year.

In other words, the growth pattern shown by the revised data sure makes it appear that the stimulus worked. The main problem would seem to be that the stimulus was not big enough and it wasn't left in place long enough to lift the economy to anywhere near potential output. But none of this was being discussed in Washington.

All eyes have been on the debt ceiling negotiations, and the default clock that many news organisations have been featuring on their websites. Of course, if anyone in Washington bothered to pay attention, they may have also taken note of the UK's third consecutive quarter of near stagnation. After all, the UK is showing us what we can expect to happen if the big budget cutters actually get their way.

But in Washington, concerns about matters like growth and unemployment have no place. We just have to keep talking about the debt and the deficit.

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