Monday, 12 September 2011

Has The Giant Stumbled?

The US has had a poor year to date. The American recovery started to run out of steam in the spring, the second round of Quantitative Easing ended in the first half of the year, and the question of Federal debt has come under the spotlight. The key debt issue was the raising of the Federal debt limit. Eventually, a temporary compromise solution was found, but the process of reaching this compromise has demonstrated the polarised nature of American politics and has weakened considerably the position of President Obama. It was for this reason that the US credit rating was downgraded from AAA to AA+.

The long term consequences of this downgrade have yet to emerge, but there are three factors to be aware of as we move into the future. First, could we take this as the opening move in the US Dollar losing its status as the global reserve currency? It is not quite a ‘Suez Moment’, but has the potential to start the process by which one emerges. How America would respond to these events is uncertain, but the world needs certainty right now, not more uncertainty. Second, the cost of borrowing in America is likely to rise in the long term, thus muting the economic recovery – which is already weak. It means that the world can no longer rely upon the American consumer to generate a recovery. Exactly where we should look for this engine of growth has yet to become clear. Thirdly, the political intransigence in America makes effective US Federal debt reduction appear even more remote. One political grouping will veto all tax rises. Another group will veto reductions in defence spending. And a further grouping will veto spending reductions on healthcare and welfare spending. It is not helpful for America to have a polarised and intransigent political system, but that is exactly what it has.

The political classes in the US are rather hoping that growth in the economy will move them out of the difficulties which they now face. With growth, overall tax revenues will rise, leaving the spending commitments much more affordable than they presently are. The question then is whether or not a presumption of growth is reasonable. In assessing this question we need to consider the point at which we are starting. The US has been hit hard by the recession. According to the US Bureau of Economic Analysis, GDP (which it measures in 2005 constant dollars, a practice which we shall continue) fell by about 6% between 2007 and 2009. During this time, US unemployment roughly doubled from abut 5% to about 10%. A recovery has been under way, but the level of GDP is still below the 2007 level and unemployment remains about the 9% level. The growth there has been is well below trend.

More worryingly, this growth has been achieved with the benefits of a $1.2 trn fiscal stimulus and two bouts of quantitative easing to the tune of $2.3 trn. The prop of quantitative easing has now been removed for the moment. Some of the temporary fiscal stimuli are also now coming to the end of their mandate. On top of this, the agreement to raise the debt ceiling institutionalised further cuts in federal spending of between $2.1 trn and $2.4 trn, depending upon whether a consensus is reached about where spending cuts and tax increases are to be incurred. Either way, the public sector support for the US economy is likely to become much reduced this year. It is for this reason that a softening of the US economy looks likely, and a double dip recession is not exactly off the agenda.

In the longer term, US politicians are relying upon the private sector to generate the growth needed to jump start the economy. This is unlikely to come through US exports – the overseas customers of US firms are likely to be facing the pinch just as much as US consumers. A weakening dollar may provide some relief to US exporters, but not at the levels needed to revitalise the economy. Both the private household sector and the private corporate sector are currently looking to repair their balance sheets, which has led to some poor consumption and investment figures. As households retrench, so will the corporate sector, as the prospects for future profits become even more limited. If there ever was a case for a fiscal intervention, now would be it.

Which brings us back to the political malaise in Washington. One of the interesting things about the American Constitution is that it is the product of conscious design. It hasn’t evolved and fallen together as the British Constitution has, but was actually designed in a way that checks and balances would prevent too great an accumulation of power. It was, however, based on a presumption of a willingness to compromise, and that willingness has been lacking in recent months. To an outsider, it seems as if the political system has been hijacked by extremists who would willingly destroy their country rather than reach an accommodation with those who do not share their view. If the extremists fare well in the elections next year, then we can expect the US economy to show sluggish growth for the rest of this decade. A modicum of common sense is a necessary, but not sufficient, condition for an American recovery.

It is possible to design a fiscal stimulus that does not increase the US federal deficit. For example, renewing the mandate to extend unemployment cover, to be paid for by a tax on the idle balances of the rich or a levy on tax-payer funded banking profits is not beyond the scope of most governments. By definition, the taxes would be levied on dead money and given to those who are most likely to spend them. If the idea of giving money away sounds too socialistic, then the unemployed could be asked to work for their benefits on a myriad of socially useful, but commercially unattractive, projects. Surprisingly, this is exactly what the financial community is looking for – a credible deficit reduction plan that enhances growth.

There is the possibility that if America does not find this way internally, then it may be enforced by an external authority. The Chinese Government – a principal creditor of the US – has already expressed its displeasure at recent events in Washington. There is evidence to suggest that China has fallen out of love with US T-Bills and is currently diversifying into other currencies. If this were to become a more clearly defined trend, then the prospect of rising interest rates in the US would be a very unwelcome turn of affairs. It is within the gift of China to force the issue through the bond markets and it is important for the political classes in America not to have the issue forced. Again, Washington needs a credible deficit reduction plan that enhances growth. We fear that if this is not achieved, the the AAA  status may not be regained, and the US may even be downgraded further.

This is not to say that the future for the US economy is all bleak. It is entirely possible for the US to enter into a virtuous circle by resuming a growth path. However, to do so will require very skilled political leadership, and that is what we are looking for when we review American economic prospects in the medium term.

© The European Futures Observatory 2011

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