Can There Be Economic Recovery Without Political Recovery

Compromise is the backbone of any negotiation, and with economic recovery at stake, it will be important for there to be political recovery to facilitate economic recovery.  There are two specific areas that Democrats and Republicans need to work on together to ensure that the US recovers from the worst recession since the Great Depression.  The first is debt, and the second is taxes.

On Wednesday December 1st, the deficit-reduction panel handed down a 59-page proposal, which they labeled "The Moment of Truth,"  which calls for sweeping changes in how the country spends money and collects taxes.  This will be the starting point for a long debate about how to tackle the U.S. debt.  The proposal would achieve nearly $4 trillion in deficit reduction through 2020, reduce the deficit to 2.3% of gross domestic product by 2015, overhaul the tax code, cap government revenue at 21% of GDP and reduce debt to 40% of GDP by 2035.

The new proposal would offer a 12% nonrefundable tax credit to all taxpayers and cap the mortgage-interest deduction to loans less than $500,000, with homeowners receiving no credit from mortgages on a second home.  Capital gains and dividends would be taxed at normal income rates. They would also limit the ability of people to deduct their health-insurance payments pretax.

Deficit reduction is extremely important over the long term.  Interest rates, are sensitive to the total amount borrowed by a sovereign nations. The world has been witness to issues that can come to the forefront when the capital markets become anxious about the ability of a nation to pay its debt.  Recently, Europe has been in the forefront of these sovereign debt issues.  Greece, Ireland, Portugal and Spain have seen their interest rates move up dramatically.  In Portugal rates have move to 6.8%, in Spain to 5.4% and in Ireland to above 8.6%.  This comes as political cohesiveness continues to evaporate in the euro zone.  The US is also witnessing issues as it related to deficits in US municipalities.  California has been in trouble for the past 2 years, and with significant deficit reduction, they are in jeopardy of defaulting on their bonds.

The second issue the US is currently facing is how to continue to have consumer spend money, when the Bush tax cuts are set to expire by the end of 2010.  There has been rumblings that the Obama administration might be willing to renew the tax cuts and roll them over for another year of two.  Unfortunately, this will widen the US deficit unless there are spending cuts in other areas.

Politically, the two parties are looking in different directions.  The Republicans were able to win a majority in the house on the back of economic uncertainty, and likely want Obama to face similar issues for another 18-24 months, to insure a Republican victory in 2012.  At the same time, the new House leadership will want to take credit for any change in the economic landscape due to the normal rebound in the economy and the efforts by the FOMC.

For the US to have deficit reduction, it will need compromise from both sides of the aisle otherwise the US might reach the same fate as our European allies.