Hamish McRae: Chances are better now, of the US fixing its deficit

Economic Studies
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The Independent Online

There is, after any memorable event, an immediate instinct to look for economic and financial consequences: the "Markets Jump for Joy at Terror Mastermind's Death" sort of thing. Well, the dollar rose a bit and the interest rate on US debt fell to a further low. But the world of money, in its prosaic way, is more interested in boring things such as interest rates and European country debt, and less in dramatic military episodes. As the financial markets began to digest the news, their enthusiasm flagged a little. It is a great story, but what does it change?

It almost certainly changes one thing. That is the likelihood of the Obama administration being able to get Congress to agree to an increase in the debt limit, when the US government bumps against its present limit some time later this month. You may recall how last month the agreement on the budget was only reached a couple of hours before the deadline, and that the government was within a whisker of a "shut-down". That sounds dramatic and indeed it was, but it had happened before on a number of occasions, and in practical terms would have mattered much less than a failure to increase the US borrowing capacity.

Presumably the long-term effect on Barack Obama's re-election prospects will be positive, but that little matter is some way off. Right now the President has had a huge gain in authority, and it would be very hard for Congress to deny him the means to carry on running the show. So that is OK.

Increasing the borrowing limit does not, however, solve the longer-term problems of the US fiscal deficit, which at around 11 per cent of GDP is proportionately greater even than the UK one. The US has been able to sustain this deficit only thanks to the special status of the dollar as the world's only reserve currency. But that is under threat. So the absolutely central question is, whether Mr Obama's added clout and the probability of a second term enable him to get the deficit on a downward path during the present growth phase of the world economy. Does he understand the peril in which the US might find itself? Probably yes, because he is able to see the country as others see it. Can he fix it? No one can say, but the events in Pakistan marginally improve his chances. That will be understood abroad by the investors who have to finance the US.

If that proves right, the chances of a better-balanced growth cycle will be much increased. We have been so preoccupied by the quite hesitant nature of the recovery in much of the developed world that we have paid less attention to the runaway growth in India and China, and the strains that is causing. Just yesterday the Reserve Bank of India increased its interest rates by half a percentage point, the ninth increase since March last year. The aim is to curb inflation of nearly 9 per cent. Last year Indian growth reached 8.6 per cent and may now be running ahead of China, which is trying to hold growth down to 7-8 per cent.

One medium-term market reaction to Bin Laden's death may be to encourage investors to buy shares rather than plunge into commodities. That is the view of Jim O'Neill, the former head of economics at Goldman Sachs and now head of its asset management arm. If that also proves right, it would be yet a further help to balanced growth because it would reduce the pressure on prices from the commodity boom.

That leads back to the central point. This particular event, huge in global political resonance and huge in US politics, is not of itself important in economic terms. But it does have a direct effect on President Obama's authority and it has an indirect effect on global confidence in US economic management. Both of those are positive. US policy matters; confidence matters. In this "two steps forward, one step back" recovery, there is a chance now of another step forward. But there will still be steps back.

Deferred pain may feel more acute

The widespread expectation a couple of months back that the Bank of England would increase interest rates tomorrow has now virtually disappeared. That move has probably been postponed to the autumn. Had growth been better in the first quarter, it might have given the Bank's monetary committee the confidence to go ahead, but the 0.5 per cent preliminary growth estimate from the Office for National Statistics has scuppered that.

But this is only a preliminary estimate, and the danger is that the Bank may be acting on wrong information. I was aware that UK preliminary estimates for growth are frequently revised upwards, but had not quite appreciated by how much, until I saw some work by Goldman Sachs on the subject. Between 1975 and 2008 there were 31 occasions when the initial estimate of quarterly GDP was negative. The average upward revision of these was just under 1 per cent, or nearly 4 per cent expressed at an annual rate. Further, if you look at the past three recessions, in the two years following the trough in activity, the average upward revision of quarterly growth was plus 0.3 per cent, or 1 per cent at an annual rate.

This does not of itself prove that the present estimates of the ONS significantly understate economic activity, but a common-sense reading of these past revisions, plus other numbers such as rising employment and hours worked, would lead one to that conclusion.

The danger for the Bank of England is that if it delays the rise in rates too long the subsequent increase in rates that it will be obliged to make will be all the greater.