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How will this tragedy end? Two Canadian views on the U.S. debt crisis

July 25, 2011 by  
Filed under Latest News, Latest Rates, Recent News

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The world is watching as negotiations to raise the U.S. debt ceiling drag on towards the Aug. 2 deadline. Republicans Friday proposed a plan to be voted on next week, hinging on cuts and caps, but the acrimony over spending or taxes continues.

Two Canadian economists have weighed into the debate, with editorials seen below. While their approach differs, their conclusions do not. If politicians cannot let reason prevail and avert a U.S. default the consequences will be dire, not only for America, but the world.

How will this Shakespearean tragedy end?

By Craig Alexander, SVP & Chief Economist TD Bank Group

The two-year anniversary of the global economic recovery has arrived, but you won’t find many people celebrating the event. This reflects the fact that we are not truly out of the crisis. Indeed, it appears that the last act of this Shakespearean tragedy has four scenes, and we’re only in scene three.

The opening three acts that covered much of the 2000s were characterized by excess, with Shakespearean flaws of greed and hubris front and centre. Act one was housing bubbles through much of the advanced world. Act two was the fundamental mispricing of risk throughout the financial system. Act three was the denial by governments, financial markets and individuals that the party could continue in definitely. This set the stage for the painful fourth act, with its four scenes.

The first scene was the financial crisis in 2008 when financial markets started to unwind the massive mispricing of real estate in many countries. This, in turn, fueled a repricing of risk more broadly across most asset classes and led to an enormous contraction in financial flows (i.e. the liquidity crunch) that threatened to seize up the global financial system. A powerful and coordinated policy response followed.

Central banks around the world took unprecedented action, slashing interest rates and injecting vast sums of money in order to permit the financial system time to wrap its head around the new financial environment in early 2009.

The financial crisis and asset price adjustment led to act four, scene two, which was the economic crisis as characterized by economic contractions and rapidly rising unemployment. Given the structure of modern economies, the second scene occurred quickly after the first scene. The inherent dilemma was that unwinding the global imbalances in a short period of time would lead to economic outcomes that were simply unacceptable to policy makers. As a consequence, enormous fiscal stimulus was injected and unheard of new policy measures were taken to limit the economic downturn and to help support renewed growth. Ultimately, the easing of monetary and fiscal policy achieved the desired goal of restarting economic growth by mid-2009, but it did not end the crisis.

The policy actions transformed one set of imbalances into another set of imbalances, setting the stage for the current scene three – the political crisis. For countries that were running substantial fiscal deficits or had unacceptably large unfunded liabilities, the fiscal response to the financial and economic crises was too costly. It also revealed the fact that many governments had made commitments to their people over past decades that were simply unaffordable. In some countries, policymakers failed in their attempt to insulate their citizens adequately to the deterioration in economic conditions. The resulting crisis has taken three forms: fears of outright government insolvency (such as in Greece, Ireland and Portugal), worries about the ability of governments to develop a credible fiscal plan for the future (such as in the United States), or a loss of confidence in the ability of governments to provide a rising standard of living for their people in the future (i.e. the rioting in various nations embarking on fiscal austerity, the Arab Spring, the emergence of the Tea Party). This third scene could be called the political crisis, the sovereign debt crisis or the fiscal crisis – take your pick. I prefer the political crisis, since it captures political friction on many fronts: between governments (i.e. Germany versus Greece); between political parties (i.e. Republicans versus Democrats); within political parties (i.e. Republicans versus Tea Party); and between people versus government (i.e. the Arab Spring).

Given that we are in the midst of scene three, there is considerable uncertainty as to how the play will end. The Bard is keeping us guessing. Most economists generally favor what can be called the ‘economic rational’ outcome.

This scenario is one where governments once again avoid unacceptable outcomes, regardless of how distasteful the policy requirements may be to their ideology. In Europe, this would take the form of a managed debt default in Greece, and perhaps Ireland and Portugal. It would ultimately require significant further fiscal transfers from the core euro countries (with IMF support) to the insolvent peripheral countries, greater fiscal union across the eurozone, and something in the order of a 50 percent hair cut on the value of insolvent government bonds.

In the United States, the rational outcome would be acceptance that a mix of higher taxes and spending cuts is necessary, but the vast bulk of the mix could be towards the latter (say roughly an 15:85 per cent split). Future entitlement spending would also have to be tackled to achieve a sustainable long-term fiscal outcome. In the immediate future, the debt ceiling must be lifted. The outcome of not doing so is unacceptable. A credit rating downgrade for America that is the holder of the world reserve currency would lead to sharply higher U.S. interest rates for all borrowers, a considerably lower U.S. dollar, not to mention the potential failure in making the required payments to citizens or a shutdown of government services. The public outrage from such a result would be so strong that a political compromise would likely come quickly, but the damage to the perceived credit worthiness of the nation would linger.

Financial markets would conclude that America cannot deal with the more substantive issue of coming up with a long-term credible fiscal plan to address deficits and the looming debt problem.

However, there is no guarantee that the rational outcome will occur. Politics can, and often does, trump economics.Given how fragile the global economy is at the moment, it would not take much to create a renewed period of financial strain and economic contraction. This is not the most likely outcome, but the possibility cannot be dismissed.

As the third crisis plays out, it leads to the final scene. The true Shakespearean tragedy is if politics wins out and the economic recovery stalls or reverses course. Worse still would be if the political crisis feeds back into a renewed financial crisis. However, if economic rationality wins out and the tough political decisions are taken, we enter a long denouement, which could take the better part of the next decade.

This scenario is where the true global rebalancing is completed. The deleveraging of the world’s advanced economies is resolved within household or government finances. For example, the U.S. economy will not be on sound footing until it has fully addressed its foreclosure problem, which is depressing home prices and impairing the financial system.

Then America must come to terms with high structural unemployment. Furthermore, the fiscal rebalancing in the U.S. and Europe must run its course.

Obviously, this outcome would not play out smoothly. Many political, economic, and financial challenges would have to be overcome. Regrettably, this best-case scenario augurs for sub-par real economic growth in the advanced world and continued extremely low interest rates over the next several years. In the late stage of the rebalancing, higher inflation will likely materialize, reflecting the hyper-stimulative monetary policy environment, which would help to reduce debt burdens and lower real exchange rates, thus helping to facilitate the rebalancing of global trade.

Elsewhere in the world, the global rebalancing will take the form of continued strong economic growth in emerging markets. Many of these countries are tackling an inflation problem at the moment, which may temporarily slow their expansions. But, the emerging markets will continue to rapidly advance their share of the world economy. Moreover, their fast economic development will support increased domestic demand, which will be partially facilitated by the strengthening or creation of social safety nets.

As this plays out, the current account deficits in the advanced world, such as the United States, will diminish, corresponding with increased national savings rates. The current account surpluses in the emerging world will diminish, corresponding to decreased national savings rates. It will also lead to foreign exchange adjustments to higher real exchange rates for the major emerging market nations.

To sum up, the last three years have felt like the last act of a Shakespearean tragedy, and this has corresponded to three scenes and three crises. We’ve been through the financial crisis and economic crisis. We’re in the political crisis. The fourth and final scene can take various forms. To simplify to two scenarios: If emotion and politics dominates, financial stability and the economic recovery is in jeopardy, and an ugly fourth scene will ensue. If rationality wins out and tough policy decisions are made with leadership and resolve, the legacy of the financial crisis will be addressed, the unrealistic prior fiscal commitments will be unwound, and fiscal policy will be put on a long-term sustainable path, which ultimately unwinds the imbalances in the global economy.

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No winners if debt talks fail

By Dr. Sherry Cooper, Chief Economist BMO Financial Group

Political wrangling is more heated than ever in Washington as the clock ticks toward the deadline for debt-ceiling legislation. According to the Administration, the ceiling will become binding on August 2, forcing the Treasury to begin reneging on its bills and its coupons and maturing bond payments. The White House says that an agreement must be reached by July 22 in order to get legislation through Congress in time to meet the August 2 deadline. With just one week to go, tempers are frayed and the rating agencies are threatening to downgrade U.S. Treasury debt, which would have a seriously negative impact on global financial markets and economic activity. This is highly disruptive for an already-shaky economy.

This political brinksmanship is irresponsible and unconscionable given the price that will be paid if an agreement is not reached. Amazingly, there are still those who believe the risks are exaggerated.

Both parties recognize that deficit reduction is essential, but while everyone agrees that spending cuts are needed, the Democrats have been heretofore reluctant to touch the popular Social Security and Medicare programs, and the Tea Party element of the Republican Party refuses to consider any actions that would increase tax revenues.

Just about a week ago, House Speaker Boehner seemed ready to forge an historic agreement with the President that would cut government spending by $3 trillion and increase tax revenues by $1 trillion over the next ten years, changing the trajectory of U.S. debt which now stands at roughly parity with GDP. The President had agreed to cuts in popular but expensive entitlements programs such as Medicare and Social Security. Many saw this as a golden opportunity for the Republicans to force the hand of Democrats to address the looming entitlements issues and remove the burden of changing Medicare from their shoulders alone (as it was seen to be in the Ryan Plan).

The revenue gains were accomplished by raising taxes on business and the wealthy through means that even most Republicans could stomach (for example, a switch from LIFO inventory accounting, charging hedge fund managers income tax rates rather than capital gains tax rates on much of their income, harmonizing corporate jet depreciation rules with those on commercial airlines — all supported by the bipartisan Simpson-Bowles commission). Stalwart Republican economists— like Martin Feldstein, a chairman of the Council of Economic Advisers under Ronald Reagan, and Gregory Mankiw, who held the same job under George W. Bush — also favour raising taxes by closing such loopholes. So did most of the Republicans from the Simpson-Bowles deficit commission.

However, Mr. Boehner’s number two, Eric Cantor, the majority leader and Tea Party sympathizer, has sided with the dozens of freshman Republicans who were elected last year on the promise to shrink government. Many believe the only real way to do that is to ‘starve the beast’ of any additional tax revenues. Mr. Boehner, therefore, appears unable to deliver the votes for such a comprehensive budget deal, so expectations have now been scaled back to a much smaller package. Senate Minority Leader Mitch McConnell, recognizing the seriousness of a potential default and downgrade, has cooked up a method by which the President could raise the debt ceiling without direct Congressional approval — although few seem to be signing on to this plan. McConnell has warned his compatriots that Republicans could well be blamed for a government shutdown, paying a significant political price.

Financial markets, however, apparently do not believe a downgrade or even temporary technical default is likely as U.S. government bond yields remain exceptionally low. Unlike in Europe, where the Greek debt crisis has spread to Spain and Italy, increasing their borrowing costs significantly, the U.S. Treasury market is still trading like a triple-A safe haven, which it is.

The fact is the U.S. has no debt crisis. Indeed, even without a compromise deal, fiscal policy is tightening dramatically in FY2012 as the earlier fiscal stimulus runs off and federal aid to the state governments declines sharply.

With unemployment high and rising, aggressive immediate fiscal tightening runs the risk of throwing the economy back into recession. Fourteen million Americans remain unemployed and more than 8 million are working part-time because they cannot find full-time work. Nearly 1 million discouraged workers stopped looking for work, taking the fraction of the population that is considered to be in the labour force to the lowest level in over 25 years.

Two huge impediments to a recovery in the U.S. jobs market this cycle have been the continued decline in housing and the layoffs in the government sector, particularly at the state and local levels. As a result of the failure of housing to recover, there has been no meaningful upturn in construction employment despite the fact that over two million jobs were lost during the recession. Developers have low inventories, so if there were to be a sustained upturn in home sales, they could easily add a few hundred thousand jobs. But, at the current time, distressed properties account for 31% of home sales and the backlog of potential home foreclosures is still enormous. The financial sector has also lost 46,000 jobs since the trough in private sector employment and more are slated to come. The negative spinoffs from residential real estate weakness are widespread.

The economy’s weakest sector is state and local governments. They have lost 577,000 jobs since the peak in August 2008— the largest loss since the Labor Department started keeping records in 1955—and have shed 165,000 jobs during the past six months. The state and local government sector is facing a $103 billion deficit in fiscal 2012. The federal government provided significant aid during fiscal years 2009, 2010, and 2011. But in the new fiscal year starting this month, this aid will decline from $59 billion to only $6 billion. As a result, the state and local government sector could lose an additional 250,000 to 300,000 jobs this year.

A federal government shutdown, in this environment, would mean additional further job losses and furloughs as well of the suspension of Social Security and Veterans’ benefits payments, unemployment insurance checks, tax refunds, etc. Government contractors would not be paid, nor would military service people. The repercussions are actually too negative to seriously contemplate, and maybe that’s why the bond market doesn’t think it will happen. Let us hope that experienced reasonable political leaders will win the day. There are no winners if these negotiations go badly wrong.

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