Hamish McRae: Obama too is forced down the austerity road

Economic Studies

We worry about the impact of our cuts in public spending but not the far, far bigger story that is about to unfold: whether the US will be forced into something even more radical. Can it really cut its deficit? And if not, what then? President Obama's budget plans for the coming fiscal year show a huge cut in the deficit: from 11.9 per cent of GDP this year to 7 per cent in 2012. That is a similar decline to what is outlined here. But the US differs from the UK in three main ways, one to its advantage, two to its disadvantage.

The advantage is that the dollar is a reserve currency. Partly as a result of that status, and partly as a result of the interdependence of the US and China, the largest and now second largest economies in the world, the US has been able to borrow to finance its deficit at very low rates. The dollar has been weak, but there is little immediate pressure for it to change course – far less than there would be on the UK or on European nations in a similar position.

Set against that are two negative factors. One is political. The US Administration does not have full control of what it spends and what it raises in tax. The President proposes and Congress disposes. Before even considering the budget for next year (the US fiscal year starts on 1 October), Republicans in Congress are seeking to trim the deficit for the current year, the one we are half through.

The problem is that more than half the spending is on so-called mandated programmes, such as Medicare and Social Security, that cannot be changed. Making meaningful cuts is extraordinarily difficult. Next year, the problem gets even greater: the Administration plans to trim lots of small items but can do little about the big ones. As for tax increases, well, they must get them through Congress.

That leads to the other negative, the maths. The deficits may be broadly similar as a percentage of GDP but the US Federal tax base is much narrower. Tax receipts this year will cover little more than half Federal spending – here they are covering more than three-quarters. We have a huge gap but theirs is huger. Worse still, on the plans just set out there will still be a deficit of 3 per cent of GDP in 2017.

The world's richest country is already the world's biggest debtor and it proposes to become a vastly bigger one. That begs the obvious question: can it borrow the money? Here there are two different views. One is to say these debts, though massive, are smaller in relative terms than at the end of the Second World War and that other countries, in particular China, have no option but to lend to the US. As a sub-clause to that, some argue it is China's fault that the US is so in debt – they shouldn't have lent it the money in the first place.

The other view is that this is both arrogant and dangerous. The arrogance shows an unawareness of the extent to which US authority is in decline, partly as a result of its financial and economic mismanagement, and of the fact that investors have other options. The danger is that there will be some sudden loss of confidence in the dollar or a surge in US long-term interest rates that would be profoundly disruptive to world trade and investment.

So what will happen? As a general rule in economics, things take longer to come to a head than you would expect and then happen more violently when they do. One possibility is a collapse of the dollar. But if the tension between the US and China gets really nasty, we cannot rule out the possibility of the US refusing to honour all or part of its foreign debts. A future Congress might claim they were unfairly accumulated – that China abused its trading relationship with the US – and therefore should be repaid at a discount.

We are not yet in anything like this position and it might seem alarmist to warn of it. It may be that with spending cuts and higher taxes the US will scramble through. In the early 1980s it faced a similar loss of confidence as a result of soaring inflation and it spent 15 years grinding away with high interest rates to get inflation under control.

But correcting this will be harder. In 15 to 20 years' time the US will no longer be the world's largest economy. Will the world be so willing to lend then?

Savers must wait for some welcome relief

Our own inflation numbers came as little surprise but were much worse than the Bank of England expected a year ago. Inflation ought not to be a problem at this stage of the economic cycle, with plenty of slack in the economy. Why is it so evident?

Two broad things have gone wrong, one long-term, one more immediate. The long-term problem is that the very things that had enabled us, and other developed countries, to have such low inflation through most of the previous 15 years have gone into reverse. The advance of the emerging economies gave us cheap products and services but their own size then was sufficiently small not to put too big a burden on world raw material and energy prices. Now costs are rising in China and India and their demands on resources are pushing up world prices for everyone.

The other is UK-specific. Sterling has been devalued by more than 20 per cent. That has pushed up import prices and companies seem more able to pass this increase through than at the time of the last sudden devaluation in 1992. Add in tax rises and the result is there for all to see.

So when will the first rise in interest rates come? Best bet would be in May, but only by 0.25 per cent. By the end of next year the market is predicting a base rate of more than 2 per cent – not high by past standards but a welcome bit of help to savers.

h.mcrae@independent.co.uk