The U.S. lame duck blitzkrieg

Today, we turn to risk #4 in our series of posts on Eurasia Group’s Top Risks for 2012 and answer the most common questions we’ve gotten about it.

Here’s a summary:

The United States- Right after elections. Congress won’t accomplish much as members face re-election and the presidential horserace develops over the first ten months of the year. But once the votes are counted, a couple of multi-trillion-dollar decisions with substantial long-term importance must be made quickly.

Q- You say that the lame duck session will be especially important this year. Why are the stakes so high?

A- Decisions have to be made by the end of 2012 on the future of the Bush tax cuts and on whether to waive the automatic spending cuts triggered by the failure of the congressional super-committee to agree on a long-term deficit reduction deal. Together, these issues will involve more than $5 trillion over the next decade, an amount large enough to have lasting influence on the trajectory of the U.S. economy. Even if there were more clarity on who will win the presidential election and on the post-election congressional balance of power, it would still be difficult to predict whether (and exactly how) the two parties can resolve these looming questions. In the meantime, companies and investors will have to cope with a lot of uncertainty in 2012 — particularly about their own taxes and government contracts. This uncertainty will also weigh on economic growth this year.

Q- Isn’t it possible that Democrats and Republicans will fail to agree on anything and that nothing will happen?

A- It’s always possible that the leadership of the two parties and the White House will fail to reach a deal. But in this case, the failure to decide is a decision, because higher taxes would automatically go into effect and $1.2 trillion in cuts to government spending will move forward. Should lawmakers fail to agree on a solution by January 1, the next Congress could move in 2013 to retroactively reverse the impact. But the next class of legislators may prove no more amenable to compromise than the current one. Even if they succeed, these adjustments and readjustments would prove highly disruptive.

Q- How will the election results play into this risk?

A- If either party takes a big hit at the polls, its leaders will have clear incentives to reach a deal on tax and spending policies before their numbers decline in the new Congress. The other side would then have most of the bargaining leverage. But if the elections produce a continuation of divided government, the two parties would be much more likely to deadlock. The realistic best-case scenario is not so great either: Both sides could agree before the end of the year on yet another temporary fix, such as a partial or full extension of the tax cuts, combined with a delay on automatic spending cuts, and punt a solution to 2013. That outcome would be less disruptive than an expiration and a retroactive fix, but it would extend the uncertainty that companies and investors dread into next year.

Next up, keeping a watchful eye on North Korea.