Editor’s note: At the time of writing, preliminary reports suggested an agreement had been reached, which cheered the markets to an extent. Last night, Congress approved the spending package to avoid a US sovereign default. Given the magnitude of this issue, this publication is putting up commentary by Stuart Thomson, chief economist at UK-based Ignis Asset Management.

Someone once said that the UK government has the engine of a lawnmower and the brakes of a Rolls Royce. The thing which makes the UK government grind to a halt is the relationship between the elected representative and the civil service. Because whereas we got into this situation by dreadful historical accident, the US Constitution actually created on purpose the doctrine of the separation of powers which ensures that the US government will grind to a halt. And it’s for the same reason; a lot of people have the power to say no, no to stop things happening. "Almost no one has the power to make things happen” - This quotation from Jonathan Lynne, co-writer of Yes Minister, the 1980s satire, sums up the farce over the debt ceiling limit in the US.

A tentative agreement has been reached which is the least that they could have done given the serious consequences of default, downgrade and financial paralysis. Politicians agreed to cut spending by $912 billion over the next decade relative to the Congressional Budget Office’s baseline scenario, which in turn implies a spending reduction of 6 per cent over this period. In addition, a bipartisan committee will determine additional spending cuts of $1.5 billion by 23 November, which in turn will be voted upon by Congress before the end of the year. In light of Jonathan Lynne’s perceptive comment, the crescendo of "no"s is likely to reach a peak in this period less than a year before the election, which in turn risks the second part of the cunning plan - envisaging automatic spending reductions of 4 per cent across the board, split between defence and non-defence expenditure whilst exempting social security, from 2013 onwards. In return the President will be authorised to raise the debt ceiling by $2.1 trillion, which kicks this particular can into 2012.

The focus on expenditure cuts favours Republican policies, but President Barack Obama also has the option not to extend the Bush tax cuts into 2013, which will effectively produce tax hikes. The focus now moves onto the House and the willingness of the fanatical Tea Party members to compromise. This leaves execution risk for financial markets tonight, but unless they are willing to take the blame for the market consequences, which we doubt, then the debt ceiling debate has proved to be the Y2K of 2011.

The solution is not what the rating agencies or the financial markets wanted, but it is as good as it gets. The rating agencies are likely to provide grudging acceptance, retaining America’s triple AAA rating with a negative outlook to help keep the politicians as “honest” as possible. America’s reputation has been damaged by this dispute, but it has also highlighted the lack of alternatives to the world’s deepest and most liquid store of value.

Indeed, we maintain that failure to pass the debt ceiling would have been bullish for the dollar and treasuries and that it would have been agencies, munis and money market funds that would have borne the brunt of investors’ liquidity preference. To the extent that this tail risk has not been triggered, the flight to quality in treasuries is likely to be temporarily reversed, but there are willing buyers on dips.

The deficit projections are highly sensitive to the CBO’s baseline projections and potential growth over the remainder of the decade. Our central bad scenario (out of the good, bad and ugly scenarios) assumes that the economy averages 1.75 per cent per annum growth over this period as government, consumers and the financial sector continues to deleverage. Inflation in this environment is likely to average 1.25 per cent, producing nominal growth of just 3 per cent. This is effectively stall speed for US labour markets, implying that the unemployment rate will remain in a 8.5 per cent to 10.0 per cent range over this period.

This will put pressure on the Fed to provide more stimulus, but the Fed cannot provide more stimulus unless inflation subsides from its current levels. More importantly, the major industrialised economies do not have sufficient escape velocity to grow out of their debt and that it will be a long and depressing slog back to prosperity.

Friday’s GDP data showed that the US economy grew just 0.8 per cent in annualised terms during the first half of the year, restrained by the contraction in government expenditure as well as higher commodity prices, bad weather and the supply chain disruptions from the Japanese earthquake. Activity will improve in the second half of the year as some of these restraints ease, but we expect the improvement to be limited to an annualised rate of just 2.7 per cent. This is lower than the 3.2 per cent consensus that has prevailed all year, but first half activity has been considerably weaker than expected even after adjusting for the special factors and illustrates the consequences of the paradox of thrift and liquidity preference amongst consumers and corporates.

The textbook solution to the paradox of thrift is more quantitative easing, but as Ben Bernanke will emphasise at his Jackson Hole speech later this month, conditions are different to last year. Growth is weaker, but inflation is higher. QE is triggered in a deleveraging environment by weak nominal growth, not weak real activity. We do not expect this to take place until the second quarter of 2012. In the meantime, we have the "Goldilocks" scenario for US Treasuries; nominal growth is neither too cold, nor real growth too hot to alter Fed policy and record low cash rates should force investors out along the yield curve compressing the air out of forward interest rate expectations.