Monday, 26 September 2011
Sunday, 25 September 2011
£1.75 trillion deal to save the euro - Telegraph
Wednesday, 21 September 2011
One potential debt crisis that has escaped our attention so far this year is that of the US States. An interesting feature of the American political system is that the political sub-units – the US States – enjoy a greater deal of fiscal freedom than many political sub-units elsewhere in the developed world. Whilst US State governments follow a more integrated monetary policy, which tends to reflect a national agenda, they also have the ability to pursue a more independent fiscal policy.
To this extent, the US system is comparable to the Eurozone. We must not follow the analogy too far because the American States are different to the Eurozone nations in that they have more of a common heritage, a common language, and a tradition of openness within a broader economy than the EU has yet to develop. And yet, we cannot but help to think in terms of California having a GDP similar to Italy, or Wisconsin the size of Ireland, and so on. It is instructive to do so when considering the issue of potential monetary instability.
The average fiscal deficit to GDP ratio in the Eurozone is about 4.2%. This average hides a wide dispersion of results, from a Greek deficit of about 10.0% of GDP to a German deficit of about 1.7% of GDP. The situation in America is slightly different. The estimate for US Federal debt is about 9.0%, which is in the ball park in comparison with some of the Eurozone nations. However, the average State debt is about 16.5% of State GDP, which is a figure that makes Greece appear to be fiscally prudent. There is some debate about the accuracy of these figures (State GDP is very hard to measure in a fluid and open economy such as the US), and we have to remember that there is also a political agenda to their estimation. Additionally, there is also a greater deal of dispersion around this mean, from Wyoming (with a deficit of about 6% of State GDP) to Massachusetts (with a deficit of about 25% of State GDP).
If we believe that the US State deficits and the US Federal deficit are additive, that would imply total public debt in the US of about 25%. This seems rather large to us, and suggests that an element of double counting has crept into the estimations. Nonetheless, we are comfortable with the conclusion that US States deficits are worse than those of the Eurozone nations, and that there is a greater variation of experience with the deficits of the US States. All of this remains hidden by the US Dollar being the world reserve currency. Just as the weaker Eurozone nations have hidden behind the collective strength of the Euro, so the US States have hidden behind the US Dollar being the world reserve currency. This has kept down the cost of borrowing for US States and has made funds more readily available than the fiscal environment would otherwise have offered without this feature.
Looking into the future, one wonders how long this will last. If the US credit rating suffers further deterioration, then there may well come a point where the position of the US States is re-evaluated in the bond markets. Just as the more vulnerable Eurozone nations have suffered the scrutiny of the bond markets, so could the weaker US States, such as Michigan or California. If that were to happen, then rather unfortunate consequences could result. In thinking about what could happen next, we have found the case of the near bankruptcy of New York City in the 1970s to be instructive.
The relative fiscal independence of the US States means just that – they are responsible for themselves. If their finances were to come under pressure, then there is no automatic mechanism whereby the Federal government would have to bail them out. If the Federal government took a position of moral hazard – that those who made the mess have to clear it up – then it is quite likely that the State governments would respond by increasing revenues (charges as well as taxes) wherever possible, along with the more likely policy of cutting back expenditure very hard. Even today, it is not entirely unknown for the staff in some States to be paid in IOUs, which are redeemed for cash by a credit union or bank. We could well see a lot more of this. It is at this point that one of the great strengths of the US economy becomes one of its weaknesses.
Although there is some migration between nations in the EU, by and large, European populations are having to bear fiscal austerity. The tax base is relatively stable and the pain of spending cuts is simply endured. This is not so in the US. Given the open nature of the US economy, given the fluidity of its labour market, and given the relative homogeneity of the population, it is far easier to move house. Often to a different State. It is relatively easy to move from fiscally imprudent New York to fiscally prudent Connecticut – you would simply be moving further up the commuter line. This feature creates an instability to the State finances. It is generally the case that the tax base is highly mobile (and will pack up and leave if taxes are seen as too high), whilst the spending base tends to be immobile. The tax base moves out, whilst the spending base stays put. For a State under pressure, this will make the situation worse.
In this future, if it came to pass, the Federal government would have to bail out the State, much as it eventually had to with New York City in the 1970s. Not because it has to, but because it is in its interest to do so. The cost of such bail outs would be truly staggering, and we can see why the Federal government is reluctant to contemplate it. This completes the circle, because a failure to contemplate the downside of the finances of the US States may well lead to a further downgrading of the US by the ratings agencies.
Most visions of the financial future do not account for adequately the inherent instability that the US State finances could contribute to the global monetary system. We feel that this is a mistake. We fear that the realisation of this weakness could lead to a sudden correction in valuations that itself could become a destabilising factor. Then we will all be wondering who will look after the little brother.
© The European Futures Observatory 2011
Monday, 12 September 2011
The US has had a poor year to date. The American recovery started to run out of steam in the spring, the second round of Quantitative Easing ended in the first half of the year, and the question of Federal debt has come under the spotlight. The key debt issue was the raising of the Federal debt limit. Eventually, a temporary compromise solution was found, but the process of reaching this compromise has demonstrated the polarised nature of American politics and has weakened considerably the position of President Obama. It was for this reason that the US credit rating was downgraded from AAA to AA+.
The long term consequences of this downgrade have yet to emerge, but there are three factors to be aware of as we move into the future. First, could we take this as the opening move in the US Dollar losing its status as the global reserve currency? It is not quite a ‘Suez Moment’, but has the potential to start the process by which one emerges. How America would respond to these events is uncertain, but the world needs certainty right now, not more uncertainty. Second, the cost of borrowing in America is likely to rise in the long term, thus muting the economic recovery – which is already weak. It means that the world can no longer rely upon the American consumer to generate a recovery. Exactly where we should look for this engine of growth has yet to become clear. Thirdly, the political intransigence in America makes effective US Federal debt reduction appear even more remote. One political grouping will veto all tax rises. Another group will veto reductions in defence spending. And a further grouping will veto spending reductions on healthcare and welfare spending. It is not helpful for America to have a polarised and intransigent political system, but that is exactly what it has.
The political classes in the US are rather hoping that growth in the economy will move them out of the difficulties which they now face. With growth, overall tax revenues will rise, leaving the spending commitments much more affordable than they presently are. The question then is whether or not a presumption of growth is reasonable. In assessing this question we need to consider the point at which we are starting. The US has been hit hard by the recession. According to the US Bureau of Economic Analysis, GDP (which it measures in 2005 constant dollars, a practice which we shall continue) fell by about 6% between 2007 and 2009. During this time, US unemployment roughly doubled from abut 5% to about 10%. A recovery has been under way, but the level of GDP is still below the 2007 level and unemployment remains about the 9% level. The growth there has been is well below trend.
More worryingly, this growth has been achieved with the benefits of a $1.2 trn fiscal stimulus and two bouts of quantitative easing to the tune of $2.3 trn. The prop of quantitative easing has now been removed for the moment. Some of the temporary fiscal stimuli are also now coming to the end of their mandate. On top of this, the agreement to raise the debt ceiling institutionalised further cuts in federal spending of between $2.1 trn and $2.4 trn, depending upon whether a consensus is reached about where spending cuts and tax increases are to be incurred. Either way, the public sector support for the US economy is likely to become much reduced this year. It is for this reason that a softening of the US economy looks likely, and a double dip recession is not exactly off the agenda.
In the longer term, US politicians are relying upon the private sector to generate the growth needed to jump start the economy. This is unlikely to come through US exports – the overseas customers of US firms are likely to be facing the pinch just as much as US consumers. A weakening dollar may provide some relief to US exporters, but not at the levels needed to revitalise the economy. Both the private household sector and the private corporate sector are currently looking to repair their balance sheets, which has led to some poor consumption and investment figures. As households retrench, so will the corporate sector, as the prospects for future profits become even more limited. If there ever was a case for a fiscal intervention, now would be it.
Which brings us back to the political malaise in Washington. One of the interesting things about the American Constitution is that it is the product of conscious design. It hasn’t evolved and fallen together as the British Constitution has, but was actually designed in a way that checks and balances would prevent too great an accumulation of power. It was, however, based on a presumption of a willingness to compromise, and that willingness has been lacking in recent months. To an outsider, it seems as if the political system has been hijacked by extremists who would willingly destroy their country rather than reach an accommodation with those who do not share their view. If the extremists fare well in the elections next year, then we can expect the US economy to show sluggish growth for the rest of this decade. A modicum of common sense is a necessary, but not sufficient, condition for an American recovery.
It is possible to design a fiscal stimulus that does not increase the US federal deficit. For example, renewing the mandate to extend unemployment cover, to be paid for by a tax on the idle balances of the rich or a levy on tax-payer funded banking profits is not beyond the scope of most governments. By definition, the taxes would be levied on dead money and given to those who are most likely to spend them. If the idea of giving money away sounds too socialistic, then the unemployed could be asked to work for their benefits on a myriad of socially useful, but commercially unattractive, projects. Surprisingly, this is exactly what the financial community is looking for – a credible deficit reduction plan that enhances growth.
There is the possibility that if America does not find this way internally, then it may be enforced by an external authority. The Chinese Government – a principal creditor of the US – has already expressed its displeasure at recent events in Washington. There is evidence to suggest that China has fallen out of love with US T-Bills and is currently diversifying into other currencies. If this were to become a more clearly defined trend, then the prospect of rising interest rates in the US would be a very unwelcome turn of affairs. It is within the gift of China to force the issue through the bond markets and it is important for the political classes in America not to have the issue forced. Again, Washington needs a credible deficit reduction plan that enhances growth. We fear that if this is not achieved, the the AAA status may not be regained, and the US may even be downgraded further.
This is not to say that the future for the US economy is all bleak. It is entirely possible for the US to enter into a virtuous circle by resuming a growth path. However, to do so will require very skilled political leadership, and that is what we are looking for when we review American economic prospects in the medium term.
© The European Futures Observatory 2011
Wednesday, 7 September 2011
Harold Wilson once famously railed against Swiss bankers – who he dubbed the ‘Gnomes of Zurich’ – when he felt that they were unfairly driving down the value of the Pound. How things have changed. Bankers other than the Swiss variety have recently been depositing their funds in Swiss Francs as a result of the uncertainty over the Euro and the US Dollar. The Swiss Franc has been seen as a ‘safe haven’ currency, which attracts large volumes of liquid funds when the financial environment seems excessively risky. The result of this has been to drive up the value of the Swiss Franc, causing the Swiss Central Bank to worry about the deflationary and recessionary consequences of a general deflation.
What to do? The traditional response would be to reduce interest rates, to make the Swiss Franc less attractive to overseas investors. The problem is that Swiss interest rates are, like those elsewhere, virtually at rock bottom. If the Swiss authorities could persuade others to raise their interest rates, then Swiss rates could fall in relative terms. The problem is that there is no great appetite for to help Switzerland in the international community. Other nations feel that they have who have too many problems of their own to co-operate with Switzerland.
That leaves managing the external rate of the Franc as the only option open to the Swiss authorities. The only tool that they have are open market interventions. If Switzerland had a regime of strict exchange controls, then managing the external rate would be much easier. It would also destroy the Swiss banking industry, which relies upon funds freely flowing into their coffers. Market intervention is a costly business. It is reported that the Swiss National Bank (SNB) has lost SwFr 10 bn already this year on defending the currency. Now that the markets sense a vulnerability – one that is possibly unsustainable – there is an incentive to bet against the Swiss Franc until the SNB runs out of money.
It is at this point that we shall see exactly how deep are the pockets of a gnome.
© The European Futures Observatory 2011