The decision by Harry Reid, the majority leader in the Senate, to cancel next week’s planned recess in order to advance discussions on the US debt ceiling is a welcome indication that Washington is beginning to view the debt issue with more urgency. Viewed from overseas, the American political system has started to appear dysfunctional in recent weeks.
Democracy is inherently a messy process, but it is still unsettling for foreign holders of US debt to see the Congress openly discussing whether there might be advantages in forcing the Treasury to “prioritise” its future payments so that the flow of interest obligations can be maintained. As Tim Geithner, Treasury secretary, has pointed out, “prioritisation” means that the US would fail to meet many of its domestic obligations which have previously been legislated. That would be taken as a strong signal of a nation in financial distress. Even worse, there would be an immediate deflationary shock to the system of up to 10 per cent of gross national product as the budget deficit is forcibly closed, which would certainly send the global economy back into recession.
No one seriously believes that any of this will be allowed to happen. But the atmosphere of political posturing does not build confidence that the longer-term problems in the US public accounts can be seriously addressed. And the country might one day need all the foreign confidence it can get. According to this week’s International Monetary Fund report on the American economy, a fiscal consolidation of 7.5 per cent of GDP will be needed to stabilise the debt ratio in the next five years. Washington should be focused on how and when such an adjustment should occur instead of attempting to score empty political points on the debt ceiling.
On this more important question, the experience of the UK is instructive. Faced with many of the same fundamental problems as the US, the coalition government in the UK has already embarked on a fiscal tightening of roughly the same scale as the IMF is now recommending for the US. Accompanying this fiscal tightening, the UK has simultaneously eased monetary policy dramatically, and encouraged a 20 per cent devaluation in the sterling exchange rate. In contrast, the Obama administration has avoided any fiscal tightening, on the grounds that the economy is too weak to absorb this.
So far, the slower American approach to fiscal tightening seems to have worked rather better than the faster British approach. Real GDP growth in the US has been maintained at about two per cent, while growth in the UK has virtually ground to a complete halt. With both countries clearly still handicapped by a severe shortage of demand, the absence of any fiscal tightening in the US may account for its superior recent growth performance.
But, in the longer term, the British approach may prove its worth. Because the medium-term fiscal adjustment programme has improved market confidence, the UK could have increased room for manoeuvre to adopt further quantitative easing if the economy weakens further, even if inflation remains temporarily high. And the automatic fiscal stabilisers could be allowed to work, without necessarily casting doubt on the sustainability of fiscal policy in the long run. Finally, the shift in the fiscal/monetary mix is helping to maintain a competitive exchange rate, which is a key requirement for the rebalancing of the British economy, as indeed it is in America.
The Federal Reserve and the IMF have both advised the political system in Washington to embark on a credible programme of fiscal consolidation, while avoiding a tightening in the fiscal stance which is too sharp in the immediate future. The IMF, and probably the Fed, see this as the precondition for a prolonged period of monetary accommodation, and (secretly) both would probably be happy to see a drop in the US dollar. None of this can be accomplished while Washington remains gridlocked, even if the Senate does cancel its vacation next week.
The writer is chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners.
Austerity Can Wait for Sunnier Days
I agree with Gavyn Davies that America has much to gain if Congress can make progress on the long-run budget problem. But I disagree on how soon the required austerity needs to begin.
Mr Davies acknowledges that “so far, the slower American approach to fiscal tightening seems to have worked rather better than the faster British approach,” and then he says, “But, in the longer term, the British approach may prove its worth.”
Though the basis for it is different, the argument is, essentially, the same as Carmen Reinhart’s. They argue that, yes, austerity is painful in the short-run but putting off the adjustments needed to bring the budget under control makes things even worse. Thus, painful as it is, immediate austerity reduces the chances of even bigger problems down the road.
I disagree with them that immediate austerity is needed. The long-term budget problem in the US is driven mainly by rising health costs, and we have many years to go before this begins to create big budget problems. Thus waiting, say, two years to begin reducing the deficit will not substantially change the probability of big problems down the road. But delaying austerity measures avoids placing a further drag on an already struggling economy, so the likely benefits are relatively large.
One of the arguments for austerity is that it would give the Federal Reserve “increased room for manoeuvre to adopt further quantitative easing if the economy weakens further”. I agree that the Fed fears being placed in the position of appearing to monetise the debt, but again I do not think immediate action is needed. A budget plan that both political parties can agree to, which is implimented only when the economy is stronger, would do a lot to give the Fed the confidence it needs to act.
I think the Fed should do more than it has been doing in any case, but it does appear that a credible budget plan is a precondition for the more hawkish members to even consider doing more.
The writer is professor of economics at the university of Oregon.