Hamish McRae: Four ways US can grasp deficit nettle
Sunday 11 November 2012
So now the race is to the cliff. The financial markets have reacted as predicted to the United States' election result, with an Obama victory indeed proving bad for equities and good for bonds. But there are other longer-term factors at work that reinforce these moves, in particular the return of jitters about the health of the European economy and a focus on the overriding issue in the world of finance for the next couple of months – how the US is going to tackle its fiscal deficit.
Worries about Europe are behind the renewed flight to the safe havens of US, German and UK debt, while the general weakness in equity markets is related in part to fears that the US might botch its handling of its fiscal position and push the economy back into recession. There may well be further weakness in equity markets ahead, but I don't feel we should be too startled by that. The US market has recovered strongly from its collapse in 2007 and the spring of 2008, rather more strongly than it did following the similar collapse in 1973-74, as you can see from the first graph. Chris Watkins of Longview Economics, who plotted this graph, has been warning that a shading back of share prices would be consistent with past experience. Shares, you could say, had got a bit ahead of themselves.
On the Europe issue, I am not sure there is much new to be said, except perhaps to note that the latest data on the French economy have been particularly worrying and that the damage to Greek society has become quite devastating: pensions being cut, yet more taxes being loaded onto the middle class, government payments being delayed and so on. The Greek exit from the euro has clearly been postponed into next year. But this is all known; what is unknown is what America will do next.
There has been a lot of criticism of the European leadership for "kicking the can down the road" of the euro but exactly the same charge can be laid against the US administration and Congress for adopting the same approach to the deficit. The difference is that the road in the US ends on 1 January 2013.
So what will they do? Well, a visit to Washington just ahead of the election left me no clearer and post-election the US commentators seem as confused as everyone else. But I suspect this is going to be one of those stories where, outside the US at least, the detail matters less than the big numbers. Put it this way: if you are working for a US defence company it matters which programmes are cut and if you are running an investment fund it matters what happens to taxes on dividends. But if you are trying to work out the likely profile of US growth next year or the long-term impact on the bond market, then what matters is the rate at which the US deficit is cut and the amount of those cuts as they come through.
That the deficit will be cut is not in doubt. It is not sustainable for a country, even one with the borrowing and printing capacity of the US, to continue spending $5 for every $3 it collects in tax. It is not sustainable partly because at some stage the rest of the world will not tolerate it. We have had similar situations before. Bill Clinton inherited a serious deficit but managed to push the Federal budget back into surplus, a great legacy for George W Bush, which was then sadly squandered. You can see the explosion of Federal debt, expressed in terms of inflation-adjusted dollars per head, in the right-hand graph. Looking at that graph, the situation appears just as unsustainable as the surge in house prices did four years ago, for whenever financial numbers move to extreme levels, common sense tells us that they will eventually correct themselves.
But how? Ignore the statements by Congressional leaders, for in the post-election shock they should not be taken too seriously. Instead, apply common sense. There are four broad possible outcomes. Outcome one is that Congress remains deadlocked and the country does indeed go over the cliff. There would be the sudden tightening of policy that would on paper be equivalent to something like 4 per cent of GDP. The shock effect would be considerable, particularly if Congress refused to agree to an increase in the debt ceiling and the government was unable to meet payroll. But I would expect after a few weeks, something would be cobbled together and though you are not really supposed to say this, a shock of this nature might be rather refreshing. It would force real change. The chances: perhaps 20 per cent.
Outcome two is that there will be a deal, with the emphasis more on spending cuts than tax increases. This is the most likely outcome, say a 40 per cent chance, but one that will be difficult to administer because the structure of US government spending is rigid: there are lot of things that cannot be cut. In macro-economic terms a gradual squeeze is probably the best outcome, but it will be difficult to do well.
Outcome three would be some cuts but with more emphasis on a radical reform of the tax system, which would increase revenues by simplifying taxes, getting rid of all the anomalies and enabling nominal tax rates over time to come down. This would be the best solution of all but it requires a determined and engaged President as well as a more cooperative Congress. President Obama would have to be much more persuasive. Chances: 20 per cent.
Finally there is outcome four, which would be modest changes to the tax system and spending patterns, with the real problems postponed. This would be the worst outcome of all, for it would undermine confidence not only of foreign savers but also of the US business community. I am afraid there must be a 20 per cent chance of this happening. If it does, then the dollar and US government securities stop becoming the safe haven, which would be bad news indeed for us all.
China seems to have found a Goldilocks economy, unlike the West
It has not, for obvious reasons, attracted as much coverage, but last week saw a change of leadership in the world's second largest economy, too.
The coverage, such as it was, focussed on the politics and on corruption rather than the economics. But while we are not so directly affected by the Chinese economy as by the American, what happens there does have a impact on us through commodity and oil prices. Faster growth in China puts more strain on both.
What China has to do in the medium-term is almost the flip side of what the US has to do. It has to rebalance its economy towards consumption and away from excessive (and often ill-planned) investment. The Chinese have, so to speak, to save less and consume more. By contrast, Americans have to spend less and save more, shifting from consumption to cutting the budget deficit and investing more in infrastructure. But in the short-run both countries need to maintain demand.
The latest signals on China's economy suggest it is managing to do that. Growth now seems to have recovered from the summer slowdown and looks like running at close to 8 per cent next year, which seems to be the level it can sustain.
You have to be careful about taking the official growth figures as correct, not so much because they are massaged, but because it is hard to collect data across such a vast country. But the hard data, such as steel production and electricity demand, seem to confirm that the summer pause is past. Steel is up nearly 12 per cent year-on-year and electricity up 6 per cent. The best news is that inflation is below 2 per cent, with food prices falling – socially very important because people on low incomes spend a high proportion of that on food.
The main point here for the rest of us is that the Chinese authorities seem to have managed first to rein back growth, which they had to do, but have now lifted it to a steady and sustainable rate. China may have achieved Goldilocks growth, not too hot and not too cold, which is more than most of the West.
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