Risk #4: Washington politics

Note: Today is the fourth in a series of posts that detail Eurasia Group’s Top Risks for 2013.

With the votes counted and the cliff averted, 2013 ought to be a year of substantial legislative accomplishment. Term limits ensure that President Obama can afford to be bolder than a first-term president in offering up concessions in exchange for tangible policy achievements. Republicans, eager for better vote results in 2014 and 2016, should be ready to prove they can get positive things done. The U.S. economy looks set for stronger growth. On energy (the shale revolution) and trade (the Trans-Pacific and Trans-Atlantic deals), there are game-changing possibilities to be had. On immigration, the two parties have incentives for cooperation, and both Democrats and Republicans have said that entitlement and tax reform are needed to boost long-term, sustainable growth.

Unfortunately, we can expect another year of zero-sum partisan combat. Elected officials from the two parties are now appealing to increasingly separate constituencies with quite different values on questions of budget and borrowing. A significant number of House Republicans worry more over primary challenges within their reliably conservative districts than about damage to their party’s national brand. Democrats, in turn, have seized on issues like immigration reform and women’s health issues to deepen their support with groups they believe Republicans are alienating. Obama says he will not negotiate over the debt ceiling. House Speaker John Boehner vows to never again negotiate privately with Obama.

Add volatility elsewhere in the world and the conviction among many investors that the U.S. remains the safest port in any storm, and complacency has begun to take root in Washington over the need to correct chronic imbalances. Borrowing costs remain low, leaving bond markets with less power to discipline elected officials than at almost any time in recent U.S. history. Absent substantial market pressure, U.S. politicians now have little incentive to risk pain by cutting spending and raising taxes in ways that would substantially reduce the federal debt.

A battle over the debt limit and government spending begins in February. Should Washington not produce a deal in time, the U.S. government would shut down, significant automatic spending cuts would take effect, and the government would default on its debts for the first time. The two sides will eventually have to find a way out of the impasse, but political and market volatility is unavoidable.

Compared with more volatile emerging markets, the downside from even worst-case U.S. scenarios is limited. But in a year when political compromise might have turbocharged growth, that opportunity is likely to be wasted.

On Friday, we’ll profile Risk #5: the JIBs — Japan, Israel, and Britain.