Why Europeans and Americans Are Addicted to Budget Brinkmanship

January 9, 2013 11:15 AM

The common refrain echoing through American politics, especially from Republicans, is that the United States must avoid, at all costs, becoming another Europe. How ironic, then, that thanks to Republicans, American and European politics have come to rely on the same sort of budget, borrowing, and fiscal brinkmanship.

On the US side, the system is so gridlocked that basic political decisions—like passing a government budget reflecting  preferences of the governing majority—cannot  be made without artificial deadlines and "cliffs."  The so-called fiscal cliff on December 31—the  combination of legislated tax increases and automatic spending cuts  intended to coerce an agreement—produced a lame budget deal that merely set up  new debt ceiling and budget resolution cliffs in the coming months, guaranteeing that once again Congressional antagonists will race  against the clock to  avert a mutually assured destructive outcome.

As pointed out here many times, however, the political processes (and the Bismarckian sausage making) in the euro area and the United States are strikingly similar. Both seem incapable of reaching agreement without the imminent fear of disaster. The Economist has even warned that US political leaders are "building Brussels on the Potomac." As usual though, London's "St. James's Street siren" is far too harsh in its assessment of the euro area in this comparison, while failing to adequately fault the policymaking incompetence of its Anglo-Saxon brethren.

The fundamental differences between the problems facing the euro area and the United States require different political strategies, of course. The euro area has an institutional design problem necessitating unprecedented handovers of national sovereignty by euro member states. Post-Westphalian states even in Europe do not like to part with national sovereignty. It is thus unsurprising that acute market pressure and the threat of imminent economic disaster (in the form of euro and/or financial sector collapse) has been instrumental in forcing the euro area's many late night agreements since early 2010. Redefining state sovereignty in the euro area (now without control over the domestic banking system and unable to engage in sovereign fiscal decisions) was never going to be easy.

By contrast, in the United States, the medium-term fiscal emergency (as opposed to containing long-term health and retirement costs) is over returning to a non-war economy with tax rates at roughly historical levels. Europe's problems are far bigger than those in the United States. While Europe must strip its members of critical parts of their national sovereignty, Congress needs merely to pass credible budgets. The fact that a political strategy of brinkmanship with built-in artificial cliffs is necessary to achieve such basic governance in Washington is testament to the American capital's political dysfunction. Market volatility and crises may be necessary for the drive to unify a continent from the bottom up in Europe. But one cannot successfully run a country if shock therapy is required to accomplish basic government tasks. But at least the recent European experiences in policymaking at the brink of disaster do provide some clues to how events will unfold in Washington in the coming months.

To understand the essence of political brinkmanship—a political strategy of deliberately pushing a dangerous situation to the edge of disaster in order to compel concessions—the best place to start is nuclear deterrence strategy and in particular Nobel Prize winner Thomas Schelling's 1966 classic Arms and Influence. Here Schelling describes brinkmanship as "manipulating the shared risk of war.... exploiting the danger that somebody may inadvertently go over the brink, dragging the other with him." In the euro area since 2010, Armageddon has loomed in the form of a collapse of the euro/euro area financial system. The risk in Washington in the coming months is obviously not war. Rather it is the threat of recession in 2013 (had the fiscal cliff not been avoided), a US sovereign default (if the debt ceiling is not raised), or a US federal government shutdown.  

Schelling describes the need for a crisis to focus policymakers' minds this way:

The essence of the crisis is its unpredictability. The "crisis" that is confidently believed to involve no danger of things getting out of hand is no crisis; no matter how energetic the activity, as long as things are believed to be safe there is no crisis. And a "crisis" that is known to entail disaster or large losses, or great changes of some sort that are completely foreseeable, is also no crisis; it is over as soon as it begins, there is no suspense. It is the essence of a crisis that the participants are not fully in control of events

In the risk terms defined by the economist Frank Knight, the essence of brinkmanship is uncertainty, which unlike quantifiable "risk" has no probability distribution. The fear of something terrible forces policymakers to take out insurance against such an outcome.

In the euro area, acute market pressure has instilled urgency into European policymakers' deliberations. Not so in the United States, where—except for the devastating fall in the stock market after the first initial rejection by Congress of the TARP (Temporary Asset Relief Program) in October 2008 (which worked wonders as Congress passed TARP four days later)—financial markets have generally  ignored Washington's political paralysis. Instead markets have generously and faithfully rewarded America's supposedly far superior political institutions and general growth prospects with record low government borrowing costs. To please investors, the United States merely has to seem better than the alternative asset classes in the euro area and Japan. Without bond vigilantes putting a gun to their heads, Congressional lawmakers have been forced to load their own guns and create their own artificial crises.  

I lament the necessity of using markets to coerce euro area political leaders into surrendering political sovereignty. But I am optimistic that a similar strategy will succeed in Washington.

But brinkmanship in Washington poses risks not present in the euro area. European leaders, for example, generally agree that a collapse of the system had to be avoided at all costs. No such consensus exists in Washington. Just because mutually assured destruction of nuclear arsenals deterred the Soviet Union and the United States from a nuclear confrontation during the Cold War, there is no reason to suppose that the same strategy would work with a nuclear armed, messianic Iran, whose zeal for jihad can be compared to the non-rational tendencies of parts of the Republican Party.

Second, cooperative outcomes of the euro area's games of chicken were facilitated by the asymmetric impact of the escalation as the common currency members moved toward the brink. Germany feels next to no economic pain until the euro actually breaks up (at which point the costs would be high). But the peripheral euro area countries have suffered a lot before a breakup, and would suffer even more afterwards.  Consequently, Chancellor Angela Merkel has been able to go slow to resolve the euro area crisis, confident that her Greek and other peripheral opponents would suffer more and earlier, and hence be likely to blink first. The costs of a crisis in the United States are not similarly found in only one party, reducing the chances of either side yielding.

Because US cliffs are politically artificial, they can be undone by kicking the can down the road, especially in the absence of market pressure. Perversely, this may negate the American advantages derived from its unified federal governmental structure, such as a system of checks and balances far less cumbersome than euro area policymaking with 17 different governments.

What, then does the euro area experience say about who would have the upper hand in the coming months in Washington?

Since financial markets seem willing to give the United States the benefit of the doubt, at least for now, it is left to the American people to assign blame for going over the next cliff. As a result, President Obama had a winning message around the New Year with his claim that Republicans were willing to risk everything to protect tax rates for millionaires. House Republicans caved and agreed to raise more than $600 billion in new revenue without getting more than a token in new spending cuts in return.

Republican Congressional leaders now believe that they have taken further tax increases off the table. If that is true, the next round of negotiations in their mind must be about spending cuts. But it is doubtful that the GOP has really increased its political leverage against President Obama on that score.

For one thing, political leverage against a president who never has to run again seems questionable. President Obama could, for example, secure his legacy by acting unilaterally to avoid the debt ceiling—by minting that $1 trillion coin or simply ignoring the debt ceiling entirely and risking impeachment and a favorable verdict by a Democratic majority Senate, rather than cave to GOP demands for spending cuts only.

The ex ante political "blame game" in the United States is always fickle and shortsighted. The Democrats' victory in the fiscal cliff confrontation is unlikely to be remembered by the American public once the debt ceiling negotiations reach crescendo and disaster looms. Indeed, precisely because the debt ceiling cliff is far more serious than the fiscal cliff (defaulting on US debt would have instantaneous market effects that the threat of a 2013 recession never had), the Republicans will likely have less leverage than they did around the New Year. With the full faith and credit of the United States on the line, what political leverage do House Speaker John Boehner and Mitch McConnell, the Senate Republican leader, really have?

President Obama will have unilateral Executive Branch options available. Even if he decides not to use them and avoids a default by halting Social Security payments, tax refunds, or defense contracts, what does the GOP stand to gain? Just as trade retaliation sanctioned by the World Trade Organization can be tailored to inflict maximum political damage on the offending nation, the US Treasury can choose payment priorities inflicting maximum public opinion damage on the Republican Party. The so-called Ryan Budget and privatization of Medicare weren't, in the end, decisive in the recent election, except perhaps in Florida, where retirees vote in large numbers. But there is no doubt that Republican demands for significant cuts in Social Security and Medicare are unpopular. Obama won Florida after all. Do Boehner and McConnell really think that spooking financial markets or threatening to shut down the Federal government over these demands will prove a vote winner? Perhaps they should consult former Senate majority leader Bob Dole, who has blamed then House Speaker Newt Gingrich's engineering of the 1995 government shutdown for damaging his 1996 campaign against President Bill Clinton.

In the end, a US sovereign default remains a trivial concern in coming months. The financial markets' complacency appears justified. The GOP idea of leverage in the next rounds of cliff games is a myth. Whether the debt ceiling fight is settled though a bipartisan deal or executive branch fiat, my guess is that it will be largely on President Obama's terms.

Republicans—so fearful of turning the United States into Greece—should recall that the first step for any country down that route is to discard fact-based, credible, and accountable governance.