Economic Outlook: The US budgetary position is a mess – in much the same way that the Pope is Catholic and bears do their business in the woods. The downgrade by S&P, the ratings agency, merely confirms what everyone already knew. The symbolism, however, is mightily important.
The debate about the debt ceiling may have grabbed most of the headlines in recent weeks but the fiscal rot set in many years ago. Even before the financial crisis, the fiscal path was unsustainable: an ageing population combined with extravagant social security commitments suggested either the need for massive tax increases or draconian spending cuts.
The crisis, however, made matters a lot worse. According to the OECD, the US budget deficit jumped from 2.9% of GDP in 2007 to 10.6% in 2010. Excluding debt interest payments and adjusting for the economic cycle, the so-called "primary" deficit rose from 1.5% to 7.0% of GDP, the biggest in the world. And the ratio of debt to GDP jumped from 62.0% to 93.6% of GDP. The eurozone is nothing like as bad: an average deficit of 6.0% of GDP, a primary deficit of 1.1% of GDP and a debt/GDP ratio about the same as America's but rising nowhere near as quickly.
Part of America's problem relates to the absence of decent economic growth. Particularly in the light of recent data revisions, we can now safely say that the US has just been through both the deepest recession in the postwar period and, importantly, the shallowest subsequent recovery. GDP is far lower than was assumed pre-crisis, unemployment is far higher and, despite massive monetary and fiscal policy stimulus, financial markets now fear a double-dip. The much vaunted "bounceback-ability" of the US economy is no more. And with future growth more likely to average 2% – in line with the average of the last economic cycle – rather than the 3% conveniently assumed by the Congressional Budget Office, the fiscal arithmetic will remain under intense pressure.
S&P's decision to downgrade US government debt reflects all of this but also, importantly, takes into account the unedifying debate in the run-up to the debt-ceiling extension. Even if Congress and the Administration have agreed that the deficit needs to be brought under control, the differences of view about how this should be done are now wider than the Grand Canyon. The compromise agreement leaves the US without any credible control over spending and certainly without any commitment to higher future revenues. It's almost as if Washington is content to treat America's creditors with total disdain.
That it's been able to get away with it until now says a lot about the depth and liquidity of America's financial markets, the lack of alternative "safe havens" in a world of financial uncertainty, the crisis in the eurozone and the peculiarities of the foreign exchange reserve policies of the Chinese, the Russians, the Saudis and others. America, after all, enjoys reserve currency status. But are things about to change? Might the S&P downgrade be more than just a symbolic gesture? Are we about to witness a revolution in world financial affairs?
Already, the Chinese are offering a critical voice. According to the Xinhua news agency, the US needs to cure its "debt addiction" or, instead, face the ignominy of more downgrades. Given that the Chinese have lent so much to the Americans – the US current account deficit is partly funded by China's current account surplus – this is a touch ironic. Yet it's easy to see why the Chinese are concerned. To understand why, it's worth thinking about the dynamics of a US government debt crisis relative to one in, say, Japan or Italy.
Japan's fiscal position is, on many counts, worse than America's. Its government debt, for example, has hit a whopping 200% of GDP. Italy's is, on many counts, better than America's. It runs a cyclically-adjusted primary surplus, a rarity in the industrialised world. Yet the Japanese government can borrow at 1% despite their fiscal weakness while the Italians have to borrow at more than 6% despite their apparent fiscal conservatism. The Americans, meanwhile, can borrow at around 2.5%.
Japan's government debt is mostly funded internally: approaching 100 per cent of JGBs are owned by the Japanese. There is no incentive to default because only the Japanese themselves would lose out. When Italy finds itself in fiscal difficulty, it either has to deliver austerity, negotiate a bailout from its European partners or default: and if neither austerity nor bailout is politically feasible, default is the only other option, shifting the burden from Italy's debtors to its – partly foreign – creditors. Hence yields are high.
The US has a secret weapon. It's called the printing press. And it's the printing press – maybe through another round of quantitative easing (QE) – which is causing such anxiety in China and elsewhere in the emerging world. Printing money helps shift the burden of adjustment away from domestic debtors to foreign creditors without the need for a formal default or a rise in yields.
If the US prints more dollars, Treasury yield will remain low (that's what QE does) but the dollar's value should decline on the foreign exchanges. That either means a stronger renminbi – in which case the renminbi value of all those dollar assets purchased by the Chinese over the years will drop – or that the Chinese also "print money" in a bid to prevent the renminbi from rising. But with inflation in China already unacceptably high, that's hardly a desirable option.
Either way, China loses. A weaker dollar, meanwhile, benefits the US by improving its export competitiveness. Higher exports, in turn, boost investment, create jobs and lead to domestic economic recovery (in the UK, this process is called "rebalancing"). Recovery, in turn, should lead to higher GDP and, hence, lower the fiscal burden as a share of GDP.
Two scenarios stem from all this. The good scenario is a new version of the 1985 Plaza Accord. The Americans agree to reduce their budget deficit on a systematic basis, weaning themselves off their incessant borrowing from the rest of the world. The Chinese agree to revalue the renminbi and other emerging nations follow suit, reducing domestic inflationary pressures. The balance of global domestic demand shifts away from the US (and Europe) towards the emerging world: in exchange for currency appreciation and the inevitable squeeze on exports, China and others boost domestic demand. Global imbalances shrink. The world is a happier place.
In the "terrifying" scenario, the Chinese and others walk away from the dollar and dollar assets before there is any commitment by the US to reduce its budget deficit. With the creditors no longer willing to fund America's borrowing habit, the US current account deficit has to decline abruptly. A fall in the dollar helps, but doesn't do enough. The only way for the deficit to decline is through a fall in domestic demand. In the absence of fiscal consolidation, only private demand can fall. Initially, this is achieved through a rise in bond yields – as the Chinese and others buy into the S&P downgrade story – but the rise in bond yields alongside a falling dollar ultimately leads to financial panic and a stock market collapse. A falling stock market, in turn, leads US investors to head for safety. They end up owning US government debt – in the same way that the Japanese own their government debt – but the cost is a period of incredible economic weakness.
With total policy paralysis in Washington, the terrifying scenario is, sadly, looking ever more likely.Reuse content