Hamish McRae: Is the US ready to bite the bullet on its deficit?

Economic Studies

Wednesday 22 June 2011 00:00
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It is not just Greece that is struggling with a yawning budget deficit. We of course are doing so, as indeed is much of the developed world. But now that Britain has begun to get things back on track the biggest fiscal deficit among the larger nations is that of the US – biggest, that is, in relative terms at around 11 per cent of GDP, and the US has done nothing about it.

But the mood is changing, as was made clear to me during a visit to Washington over the weekend. Indeed this week is the moment when the serious debate on what to do has begun. Up to now the US has seemed almost insouciant about its debts. Some commentators are still calling for an even bigger deficit to "jump-start" the recovery and are genuinely puzzled that the UK economy seems to be managing to create a lot of new private sector jobs despite fiscal retrenchment, whereas the US, despite somewhat higher published growth figures, is failing to do so.

For the past six weeks there have been on-and-off talks in Congress about what to do. Put crudely, the Republicans want the emphasis on cutting spending while the Democrats want it on increasing taxes. Result: impasse. But now the pace has picked up, with the aim of the vice-president Joe Biden to get something agreed by the 4 July holiday.

There is a hard deadline, as opposed to the soft one of a national holiday. It is that the US government runs out of money at the beginning of August unless Congress agrees to an increase in the country's borrowing ceiling. This may seem an odd system to Europeans, to whom the idea of a legislature blocking a government is unthinkable: in a parliamentary system the government would fall and be replaced by another. Self-evidently it has not been a successful device for limiting US federal borrowing.

The outcome in all probability will be some sort of agreement where there will be some $2tn of savings, matched by a similar-sized increase in the debt limit. It seems to be recognised that there really has to be agreement, as if there were not, the US would have at least a technical default: it would not be able to pay some of its obligations as they became due. Something – federal salaries, debt interest, whatever – would go unpaid. The US present AAA credit rating would be downgraded, increasing borrowing costs for the nation.

Two further factors have entered the equation. One is Greece. According to Joe Biden, Congress has to convince the financial markets that, unlike Greece, the US political system can at least take difficult decisions. The other is China.

China holds $1.15tn of US treasury debt. Until this year it seemed willing to go on increasing that stock; it protested about the US deficit but kept signing the cheques to finance it. It looks as though this may have changed. The figures are opaque but during the latter part of last year and the early part of this, China seems to have stopped building up US debt holdings. It seems to be switching its investments from dollars to euros.

Euros? Right now? Well, this is a beauty parade of the ugly. None of the major currencies, with sterling and the yen the other two held internationally in significant quantities, are very attractive. Indeed – and this is really interesting – the euro, despite the antics of the "Club Med", has held up rather well. It is almost as though the Chinese and other international investors are saying: "Look, we are grown-ups. We know that Greece will default and that some countries may well leave the eurozone, but for the moment we trust the European Central Bank to preserve the real value of the euro more than we trust the Federal Reserve to preserve the value of the dollar."

Even if the US does reach some sort of budget deal, this will not fix the deficit in the medium-term. Far bigger changes, both in higher taxes and lower spending on "entitlements", spending that the federal government is committed to, are needed to do that. So a deal will not dissipate the self-searching mood of many Americans.

The fact that the recovery has done little to cut unemployment, that house prices in most cities are still falling, that families carry a huge burden of debt, that fuel prices are close to record highs – all these seem to confirm that the good years are past. The fear is that the US will experience a "lost decade" similar to that of Japan in the 1990s.

Actually there is no comparison, for among other differences the US still has the youngest population of any developed country, whereas Japan has the oldest. There are other huge strengths too, not least that the US remains a magnet for the world's most talented and energetic people. But it, like everyone else, has first to fix its fiscal deficit – and the rest of us should hope that it will.

Grim reading, but not without hope

We now have numbers for the first two months of the new financial year and it is hard to be encouraged by what has happened to our national finances. The deficit is up on last year, not down. But this is not as bad as it looks as the cash coming in last year was inflated by the one-off tax on the banks and underlying revenues for the first two months look all right. Spending is up, which will surprise many, but allowing for the inescapable extra interest payments, that seems under control.

The figures give us three main messages. First, the economy is indeed growing, albeit slowly, for the increased revenues confirm that. A second is that the return to some sort of fiscal balance is a daunting as ever. And the third, more tentative, is that we may miss the fiscal target this year but if we do, the investors who have to cover the extra deficit will cut us a bit of slack.

h.mcrae@independent.co.uk

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