In 1992, with the United States in the midst of recession and presidential elections just around the corner, James Carville, excellent advisor, hung a famous sign in the office of the Democrat candidate to make sure he understood what his campaign's focus should be: «it's the economy, stupid!»
Bill Clinton took this seriously, defeated President Bush senior and the rest is history. Twenty years on and just one month from the elections, with the general government deficit close to 8% of GDP and debt above 105% of GDP (see the graph below), the epicentre of the electoral debate is once again obvious: it's the deficit! The United States is facing a huge challenge of fiscal consolidation within an economic situation that is still being hindered by the consequences of the great recession, and the candidates disagree as to how this should be done: Obama believes that revenue should be increased while Romney wants to cut spending.
In the fray are two models that differ on fundamental issues: the size of government, the composition of spending and which taxes to use.
At the beginning of 2013, an incredibly extensive and sudden fiscal adjustment is expected but, nevertheless, it is not credible, desirable nor would it be enough to restore the sustainability of public finances. This adjustment would result from the end of a series of fiscal stimuli and automatic cuts in spending legislated during the summer of 2011, when Congress raised the federal government's debt ceiling.
This would result in a correction equivalent to 4% of GDP, which would very likely push the American economy back into recession. It's not surprising that this adjustment has been called the «fiscal cliff» and the new administration's number one priority will undoubtedly be to avoid such a precipice. Moreover, it would be a good idea to do so within the framework of a plan that ensures the sustainability of public debt in the medium term.
The outcome of the elections could make it easier or harder to handle this «fiscal cliff». The vast majority of analysts (including ourselves) expect an agreement to be reached in Congress (the House of Representatives and the Senate) to postpone the automatic spending cuts and extend some of the stimuli that end in January, but the composition of the new Congress and the identity of the President will be decisive in this respect.
If one of the parties receives a clear mandate from the electorate, an agreement will probably be reached relatively quickly to avoid the «cliff». However, a relatively unclear mandate (with the houses divided and only a minimal victory by either of the presidential candidates) could prolong negotiations, leading to uncertainty and a lack of confidence. Moreover, in February, the federal government will need to approve a further increase in the debt ceiling, providing an additional source of uncertainty.
Having dodged the cliff, the composition of the houses and the President's identity will obviously determine the fiscal adjustment strategy in the short and medium term.
Obama proposes increasing the relative weight of the federal government's revenue (which currently accounts for around half the total public administration revenue) from the 15.7% of GDP estimated in 2012 to 19.4% of GDP in 2015. With regard to spending, he proposes reducing its relative weight from 22.9% of GDP in 2012 to 22.4%. So the federal deficit would fall from 7.2% estimated for the 2012 fiscal year to 3% of GDP in 2015, and 85% of this adjustment would fall on revenue.
Romney proposes reducing the relative weight of spending much further, down to 20% of GDP, and increasing revenue to 18% of GDP (the average in the two decades prior to the 2008 crisis). The Republican candidate's aim is to reduce the deficit to 2% in 2015 and 55% of this adjustment would be carried out via spending. The cut in spending would be achieved via extensive adjustments in so-called discretionary spending (including investment) and other measures such as public healthcare reform.
In the plan of both candidates, the increase in revenue would mostly, or totally in the case of Romney, come automatically as a result of the economic recovery.