Hamish McRae: US fiscal woes stem from structural problem afflicting developed world
Sunday 31 July 2011
Amid the ructions in Washington about the debt ceiling, there is something much bigger happening.
It is not just narrow party politics but how a democracy copes with long-term fiscal challenges. The issues are to what extent should the government have control over decisions that have consequences 10 or more years away and, if the government is not to have full control over fiscal policy, what should take its place?
This is a problem for the US. Its legislature is struggling to tackle that problem. But it is also a problem for us here, as it is for every democracy in the world. The difficulties are more apparent in the fiscally challenged countries, but even those that seem least threatened, such as Germany, are following policies that are unsustainable.
Once you accept that this is a global structural problem, rather than a national political one, you can get some perspective on events in the US. The parallel I find most helpful is that of monetary policy in the 1970s and 1980s. Inflation and interest rates soared into double digits and people wrote of democracy itself being under the gravest threat.
Gradually, slowly and painfully inflation was brought under control, leading eventually to giving central banks in much of the world a mandate to curb inflation and the power to set short-term interest rates as their main means of carrying out that mandate. We accept the new model as normal. Whatever criticism people make of the Bank of England, no one suggests going back to the old system. This separation of power is even more evident in Europe, where politicians have ceded all authority over monetary policy to the European Central Bank.
However, the present fiscal challenge does not, in Britain at least, feel quite as serious as the monetary challenge of 30 years ago. That may be because we have only just begun to tackle it; maybe it is because many people still don't quite understand the scale of the problem or, if they do, they still think we will have four or five difficult years and then it will be business as normal.
On the other hand, it feels very serious indeed in much of Europe, with borrowing costs for Italy and Spain rising following the Greek bail-out, and Spain threatened with a ratings downgrade. And it feels serious in the US. Last week an unusual event occurred in the markets: the rate of interest on US 10-year treasury bonds rose to about the rate on equivalent gilts. Suddenly the UK, despite our fiscal deficit of 9 per cent of GDP and our weak pound, has become a safer haven for spare cash than the US.
We should see what is happening in Congress in the context of the efforts in other countries to find a constitutional mechanism for establishing new rules for fiscal policy. Here we have the Office for Budgetary Responsibility, a body which is still very new. In Europe, there are the first halting steps towards central fiscal control. At the moment this is only being imposed on countries that have to go for a bail-out, but things have moved quite fast in the past year.
The thing that I find most intriguing is whether the Tea Party movement will come up with fiscal rules that shape policy beyond America. Here in Britain that might seem slightly shocking – remember how Vince Cable dubbed the people blocking the increase in the debt ceiling as "right-wing nutters". But the movement is one of many efforts globally to create a framework for fiscal policy. I happen to think the Tea Party ideas are not very coherent, but they have more democratic legitimacy than the rules being imposed in Greece by Brussels, Berlin and Paris.
The biggest question of all is how long it will take for the new global framework to evolve. My guess is that it will take another decade before things settle down; we probably have to experience another global downturn first. But if the prospect for this expansion is so gloomy, why have we not seen more of a collapse in share and commodity prices? I know we have had a poor couple of weeks, but the price-earnings ratio on US shares is still well over 20, above the long-term average of 16, as you can see from the right-hand graph.
The markets, or at least Wall Street, seems to be taking this global fiscal crisis pretty much in its stride. Sure, we have had a decade when share prices have gone sideways, but when you consider the absurd overvaluation of 2000, even higher than the 1929 peak, it would be pretty odd if this were not some sort of bear market. There have certainly been worse bear markets, notably in the 1970s.
That leads into a debate about the relationship between stock markets and the world economy. The graphs come from Chris Watling at Longview Economics. He believes the present bear market still has some way to run – they normally run for 10 to 20 years and price-earnings ratios typically dip to single figures before a sustained bull market begins. If that is right, we have another decade of, at best, sideways movement in share prices. As you can see from the yellow chunks of the left-hand graph, there was a long bear period from the 1890s through to 1920, a relatively short bull market in the 1920s, and another sideways movement through to 1950 before the post-war boom took hold.
Then came the period I find most relevant to today, the 1970s, the period of the monetary catastrophe. What is really interesting is that the market recovery started around 1982, in the very early stages of the return to monetary discipline. It is as though once the markets could see that the policy-makers were getting a grip, confidence returned.
And now? Well, the policy-makers in the emerging world are doing rather better than those of the developed world, which might justify present price-earnings ratios. If you are Exxon or Apple, you care about the world economy, not national ones. But I am sure of one thing. Share markets cannot stage a secure recovery until fiscal policy in the developed world is on a sound footing. That, sadly, is still some way off.
Gloom is overdone in the UK, but the US isn't working – and that is worrying
It never rains but it pours. The second-quarter growth figures for the US were disappointing, up only 1.3 per cent annual rate, but more troubling was a nasty downward revision of earlier data. First-quarter growth was only 0.4 per cent annual rate, while further revisions show that the fall in the economy from peak to trough was 5.1 per cent, against earlier estimates of 4.1 per cent. The US economy is still below its previous peak.
US first estimates for GDP are typically higher than subsequent data reveals; that is, revisions are nearly always down rather than up. In the UK, revisions tend to be up, for reasons I don't fully understand. But this new US data puts an interesting spin on the relative performance of the US and UK economies in this cycle.
Our numbers still show that we have fared much worse than the US, with a fall of 6.4 per cent peak to trough. But if you take out the decline in offshore oil and gas and look at the onshore economy, the fall was 6.2 per cent, and that is before our own full revisions.
There is still a big gap of course, but it is plausible that we will be shown to have had a similar recession to the US, not a worse one. And, as noted by Simon Ward at Henderson, the recovery of the onshore economy, even on the official figures, is running slightly ahead of the early-1980s cycle. None of this is to suggest anything other than disappointingly slow growth and we are unlikely to get back to the previous peak in output until the back end of next year. But, as he points out, the gloom is overdone.
The gloom for the US may not be overdone. What is worrying is the jobless nature of the recovery. There will be fiscal retrenchment next year come what may; it is already happening at state and municipal level. I often feel the preoccupation with data is unhelpful. What matters is that the great US job-creation machine gets moving again – and there is worryingly little sign of that.
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