Grand bargain: time for a second famous American dinner party.

• Author: McKinnon, Ronald

The recent spectacle of the two major political parties in the United States being unable to agree on any action that would close the gaping federal fiscal deficit--more than 9 percent of GNP--is both unedifying and bewildering. In past decades, similarly tense political disputes over actual or projected fiscal deficits, if left unresolved, have induced sharp increases in interest rates that have focused the minds of politicians worried about a credit crunch. But now with the Federal Reserve keeping short-term interest rates close to zero, and central banks in emerging markets and the Fed itself buying huge amounts of longer-term U.S. Treasury bonds, interest rates have not risen. This crucial source of market discipline on fiscal behavior has been euthanized.

Setting an artificial deadline to force Congress to raise the limit of $14.5 trillion on the outstanding federal debt or risk being censured by the electorate for severe disruption of federal payment obligations cannot lead to anything better than a short-run palliative. Far better for tile two parties to agree on the basic principles of a "grand bargain" on fiscal reform, and then leave enough time for careful consideration of its legislative and administrative implementation.

In 2011, the philosophical differences between the two sides are so great that any successful grand bargain must force each side to give up a cherished belief--but a belief that is damaging the economy and harms the general welfare. There must be blood on the ground, as the more extreme supporters on either side are outraged when the bargain is concluded so that the economy can improve.

Perhaps a look back to the late eighteenth century could provide impetus for such a grand bargain. After the Revolutionary War, in 1790 the fledgling U.S. government also faced paralyzing gridlock between two major protagonists over a huge, seemingly unsustainable, debt problem that threatened the future creditworthiness of the new republic. During the war, the taxing ability of most of the individual states eroded. But to support George Washington's Continental Army and cover ordinary government expenditures, many states, particularly in the North, borrowed by issuing paper notes. By 1790, most of these notes were threatened by default. Speculators had purchased many from their original owners, such as war veterans, at steep discounts. To establish confidence in the nation's near-moribund financial markets, the first Secretary of the Treasury, Alexander Hamilton, proposed a one-time assumption of the state debts by the new federal government.

However, unlike their less provident northern neighbors, the Southern states, notably Virginia and Georgia, were not threatened with debt default and opposed federal assumption. Their residents were also concerned that federal purchases of discounted...