Best stimulus for the global economy is a US budget deal

There is no shortage of economic news this week. How much of it, including the appointment on Thursday of Hu Jintao’s successor, Xi Jinping, and other members of China’s new leadership, will be market moving is another matter. But what happens on Friday will matter big time for equity markets, as this is when the US President is scheduled to meet with John Boehner, the House Speaker, and the other leaders of Congress to talk about how to move forward on a deal that avoids the fiscal cliff.

How’s this for an opener?

‘For purposes of forging a bipartisan agreement that begins to solve the problem, we’re willing to accept new revenue, under the right conditions.’

That was John Boehner, the Speaker of the US House of Representatives, talking. He said this shortly after the re-election of President Obama. Like everyone, Boehner wants a growing economy, except he wants it ‘energized by a simpler, cleaner, fairer tax code, with fewer loop holes, and lower rates for all.’ He also wants a growing economy supported by ‘concrete steps that put [the] country’s entitlement programs on a sounder financial footing.’ For Boehner, the right conditions are a restructuring of the tax code and a reform of entitlement programs.

Late last week President Obama responded with his own ‘right conditions’. Sure, the President is prepared to compromise, but that is so long as a deal includes a tax increase for the wealthy. As the President put it, ‘If we’re serious about reducing the deficit, we have to combine spending cuts with revenue. And that means asking the wealthiest Americans to pay a little more in taxes.’

If this is conciliatory, the markets may wonder where intransigence comes in. They may find out on Friday though it is to be hoped that reason prevails. As recent work reported by the IMF on fiscal multipliers suggests, a recession could be both deeper and more protracted than that projected by the Congressional

Budget Office. The latter forecast a drop of 0.5 percent in GDP from the fourth quarter of this year to the fourth quarter of 2013, with the decline coming throughout the first half of next year followed by a modest recovery in the second half.

Equity markets aren’t counting on anything but a deal. However, the key is agreeing to a framework for fiscal consolidation that alleviates some of the uncertainty inhibiting growth and lessening the effectiveness of monetary policy. Because a ‘grand bargain’ is seen as unlikely between now and year-end, what markets would like to see is some of what has already been proposed, notably agreement on a broad framework that could set the stage for discussion next year on deficit reduction and debt sustainability and thus raise the likelihood of what would comprise the ‘grand bargain’.

As a start on where the discussion might go after Fridays’ meeting at the White house, the indication is that an agreement to introduce a not-so-ambitious programme of spending cuts and to alter the tax code partly by limiting tax breaks for higher income earners is a possibility. The latter would bring in revenues without raising tax rates and be in keeping with the respective positions of both Republicans and Democrats.

On what else might move equity markets, the earnings season is pretty well complete in the US and Europe and there is little more that markets can gain from the companies that have yet to report. The message is that the bottom line has performed modestly better than expected but the top line has thoroughly disappointed, due in large measure to the loss of momentum in the growth of aggregate demand throughout the global economy.

A deal on US budget policy that mitigates the prevailing uncertainties inhibiting growth and lessening the effectiveness of monetary policy would surely provide the best stimulus for the global economy. It would be great news for equity markets that are beginning to look a little oversold. Maybe this is what they will discount as the week progresses.

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