Hamish McRae: Whatever battering Obama takes in this week's poll, he must rein in the US deficit

Economic View from Washington DC

The politics for President Barack Obama look pretty dreadful, with the predictions for the mid-term elections on Tuesday looking somewhere between dire and catastrophic.

But the economy? Well, the economy is the principal reason for the President's unpopularity and the recovery from recession has certainly been muted and uneven. But to this visiting outsider, the fact that the mess was entirely inherited from his predecessor is not appreciated as much as it should be, and on a two-year view there are reasons to be slightly more optimistic – provided one huge matter is dealt with effectively.

More of that in a moment; first, a caution. The nation's capital is not the nation. Washington DC has an unusual economy and has been protected from the worst of the recession sweeping across the rest of the country. Government or government-related employment has been maintained, which has held up consumption and housing demand, which in turn has supported house prices. So the regional economy has not had to face the wave of foreclosures (which the government is now trying to put on hold) that has savaged states such as Florida, Arizona and Michigan. People may be worried about their economic futures, and understandably so, but there is not the wave of fear felt elsewhere, and impressions gathered here may be misleading.

Still, the fact remains that the US economy is growing. Figures out on Friday showed third-quarter growth running at an annual rate of 2 per cent, quite a bit slower than the long-term trend. True, consumption was not too bad, up by an annualised 2.6 per cent, but while exports did well enough, imports shot up, which will reinforce the calls in the new Congress for some sort of import controls. There is the further problem that the impetus for growth this year has come to some extent from the stimulus from the federal government, and this runs out in 2011. The ending of one particular initiative, tax rebates on home purchases, ran out in April, and already the housing market may be heading down – figures vary from location to location but for the past two months the tiny housing recovery seems to have stalled.a further boost from the Federal Reserve is widely expected, with an announcement of another bout of quantitative easing this week, so the monetary accelerator pedal will continue to be pressed to the floor. How effective that will be is unclear.

If you compare this recovery with previous economic cycles, the main differences are that growth has been towards the bottom end of the scale and growth in employment has been the slowest of any since the Second World War. Unlike in the UK and much of Europe, particularly Germany, US firms cut labour sharply as demand fell off and failed to rehire as it returned. So productivity numbers are great but unemployment numbers terrible. The good news is that as demand picks up, firms must rehire; the bad, that demand may not pick up much.

The consensus view of the US business community was reflected at The Economist's Buttonwood conference in New York: that there will not be another leg to the recession but that the recovery will continue to be sub-standard. The conference brought together business leaders, bankers, economists and officials in an informal, none-too-earnest way. The lead speaker was the former treasury secretary, Robert Rubin, who headed a simulation, with a pretend White House economics team, as to what they would do if an imaginary US state, New Jefferson, was about to default on its bonds. As they debated, various bits of news came in on the wires, including concerns from China about US debt. Their conclusion was reluctantly to bail it out, setting various fierce conditions on the loan. A touch of the eurozone and Greece, you might think.

So: a slow recovery and a jobless one; a stalled housing market; rising fears of protectionism; and fears that a state might default. What rational reasons are there to be even cautiously optimistic?

The principal one – and I suppose I feel this whenever I am in the States – is that the natural condition of the US economy is growth. There is population growth, and there is the space to accommodate this. There is also an ability to adapt, to create new business models and new applications for the technology the country develops. That is why the US is not the new Japan.

Think two years down the line, when Mr Obama comes up for re-election. By then, there will have been three years of growth. The housing market will have had two years of price stability, maybe even some gains. The federal government will be showing a profit on its investments in the motor industry rescues and maybe on its banking interventions too. At the very least, that cost will be capped and clear. There may well have been some further bail-outs, on the New Jefferson model, but the US will be through that by then. Given the inheritance, it won't be a bad record.

So what is the huge matter noted above? Have a look at the graphs. They show the divergent fiscal paths taken by the US and its northern neighbour, Canada. Only three years ago, the stock of public debt in Canada, relative to GDP, was higher than that in the US. But Canada ran surpluses during the boom and now looks like seeing a return to fiscal balance within five years. The US, by contrast, not only added to its debts during the boom years (as indeed did the UK, so we can't talk) but is projected by the IMF to keep adding to its debt mountain right through to 2015. Even more alarming, by then the running deficit will be rising again.

At some stage, and no one can predict when, the US becomes not the new Japan but New Jefferson – unless, that is, Mr Obama carries through the plan that he is talking about, which is to bring the deficit back under control. That cannot be done in the next two years but has to be done in the next six. The machinations of American politics are hard for any European to understand but fiscal mathematics is ultimately the same on both sides of the Atlantic.

What we need is an EU state to default to stress-test the new 'crisis mechanism'

Beware the headlines from Brussels. I don't mean that as a criticism of meetings at the European Commission, or indeed of the headline writers. It is simply that the first interpretation of any agreement over the future direction of Europe often proves to be wrong. Sometimes things turn out to be more important than they seem at the time, for example the opt-out for Britain negotiated by John Major over the euro, and some less so, such as the Lisbon Agenda in 2000, which was supposed to transform the European economy.

We now have a new agreement between heads of government on how to cope with the threat of another Greek-style default. There will be stricter fiscal rules and a "permanent crisis mechanism", which may need amendments to the EU treaty. And voting rights may be suspended for countries that misbehave. Proposals from the Commission will be drawn up by December.

This all sounds rather sensible. If the Germans have to bail out weaker eurozone members, there has to be some sort of discipline imposed on the miscreants. Otherwise, it is an open chequebook. But the devil will be in the detail and the past decade shows that discipline, ultimately, will be imposed by the bond markets, not the EU.

My own feeling is that we need a default. We need a eurozone state to acknowledge that it can't repay its debts when they fall due. The markets are pricing that into Greek debt as a probability but there may be others. Then we need to see how Europe reacts and how the market reacts. We will learn whether these Brussels agreements have substance, or are meaningless when stress-tested. To have a "permanent crisis mechanism" appears a contradiction in terms. You cannot predict the outcome in detail, nor the timing. All you can say is that it is, in general, healthier for the long-term future of all financial relations to have problems out in the open.