The economy will dominate the problems that confront the winner of the 6th November election, but this is an election worth winning. Either President Barack Obama or Mitt Romney will benefit from the way that the US economy has adjusted in the wake of the 2008 financial crisis—better than anywhere else.
For investors this means that, after some turbulence this winter, the US stock market could yield solid returns, with better growth than Europe or Japan, and probably outperforming all but a few emerging markets as well.
As soon as the election is out of the way, the White House and Congress will be facing the “fiscal cliff” on 31st December, the result of their failure to agree on a budget earlier in the year. Laws are already in place to make budget savings and the expiration of tax cuts from the George W Bush era is also scheduled then. That would enforce a fiscal tightening of a massive five per cent of GDP, unless all parties can agree on a new budget.
No doubt, politicians will find a way to soften these changes, as the result of actually making them would almost certainly be a major recession. But some remnant of the “cliff” will probably remain in place. Although this could slow down the economy in the first half of next year, it is a big step towards an essential element of the US’s adjustment after the crisis: control of its public sector deficits, and its debt levels, in the face of rising healthcare and pensions.
One paradox of the 2007-08 debt crisis was that the world savings rate—the share of world income saved—was the highest on record. In Japan, China, the Asian Tigers, Germany, Benelux, Scandinavia, Switzerland and Austria, savings were far larger than profitable investment opportunities between 2004 and 2008. The result was a global decline in real interest rates, which spurred property and construction booms in the US, UK, Ireland, Mediterranean Europe and elsewhere—much of it essentially wasteful. It also prompted households in those countries to save much less than in the past. Believing their houses were suddenly worth much more, people spent more or saved less.
To achieve export surpluses and send excess savings abroad, countries with savings gluts had to ensure that they were exceptionally competitive on costs. China secured this by retaining the undervalued yuan-dollar peg, which was shadowed by “soft pegs” in Japan and elsewhere in the Pacific rim. Germany and surrounding Mediterranean countries had falling relative costs courtesy of the euro.
The crisis started in mid-2007 with the widespread collapse of supposedly off balance-sheet “financing vehicles” holding mortgage-related derivatives, often based on subprime borrowers. That removed a temptation for American households to spend more by shutting off the route to this wasteful investment. In turn, the world savings rate jumped to an all-time high, leading to recession from early 2008. Several months later rickety global finances collapsed as Lehman Brothers went down.
The resulting crash brought worse recessions to saver countries including China, Japan and Germany than it did to the US. These countries had been dependent on exports. So China was determined to hold onto its undervalued exchange rate, while Germany retained the equivalent through its membership of the euro. Only Japan saw its exchange rate soar, making the dollar, in effect, slightly devalued.
The only way the US economy could have recovered healthily while households saved more was through export growth. If the countries with savings gluts had taken measures to encourage their citizens to spend more, consumption would have risen. Aided by a rise of their currencies against the dollar, the result could have been an increase in US exports.
But this did not happen. Japan could not raise consumption but did let the yen soar. As a result, it has had a dismal recovery. Germany regards saving as inherently good, and economics as a branch of moral philosophy; it told others to be like Germany, holding onto its low costs within the euro structure. China carried on saving more than half its GDP and simply launched a wasteful initiative that took investment from 42 per cent of GDP in 2007 to 50 per cent last year.
Deprived of the needed devaluation to complement domestic austerity, America instead used budget deficits—more spending by the federal government—to revive its economy and offset the forced adjustment to household balance sheets. The budget deficit peaked at 12.5 per cent of GDP in mid-2009.
So America moved out of the household-debt frying pan, into the budget-deficit fire. Americans railed against China’s policy of pegging the yuan to the dollar, which was seriously cramping their freedom of manoeuvre. But ironically, China’s policy damaged its own economy in precisely the manner needed to solve America’s problem. The excessive stimulus to wasteful investment, and China’s leaders’ insistence on keeping the currency undervalued, gave it inflation—big time.
It is habitual to look at the consumer price index, a monitor of the price of key household goods, which never rose more than 6.5 per cent. But consumer spending is less than 35 per cent of China’s GDP expenditure, compared to 50 per cent for investment and nearly 30 per cent for exports. The prices of the last two were rising at an average of eight per cent a year for more than two years. Labour costs grew by some nine per cent a year for even longer. Meanwhile the cost of US labour rose by negligible amounts.
Contrary to much of the still-excited projections about China’s export strength, the country had become seriously uncompetitive in exports by mid-2011. America had achieved devaluation in its currency—through Chinese inflation. Investment in fixed assets by US businesses has grown by ten per cent over the past year, even though the economy has been growing at only 2.2 per cent annually for the past three years of weak recovery.
The flight of investment and jobs to China and the Pacific rim has been halted. The slow recovery—US recoveries normally see four to five per cent real GDP growth for two to three years—reflects the rebalancing of household finances (paying off debt), and a decent start in getting the budget deficit under control. Household debt, nearly 130 per cent of disposable income at the peak of the crisis, is now below 110 per cent.
With the current low interest rates, home-owning households are paying out about 14 per cent of their disposable income in servicing debt, at the bottom of the sustainable range of 14 to 15.5 per cent that prevailed in the 1980s and 1990s. Debts are under control and housing is starting to revive. The federal government has also managed to cut the public sector deficit from its 12.5 per cent peak to 8.5 per cent in the second quarter of 2012. The tightening has been impressive but is far from over, a crucial point in understanding the argument about the fiscal cliff.
On the Federal Reserve’s definitions, US public sector debt has risen to about 90 per cent of GDP, from the 50 to 60 per cent region that prevailed in the 20 years to 2007. If it is to be contained at or below 100 per cent, each year’s incremental addition to the deficit must be less than incremental GDP; that is, growth in the economy, including inflation. The latter could be four per cent; within that, real growth might be two per cent. So the recent shift gets the US less than halfway there. The full fiscal cliff of five per cent would finish the problem off in one fell swoop—except that it would probably finish off the economy too.
The fiscal cliff includes 1.5 per cent of GDP for the 2003 Bush administration tax cuts on “ordinary” people, which are due to expire on 31st December but are sure to be perpetuated. Excluding this, the argument is about the expiry of tax cuts for the rich (0.4 per cent of GDP), payroll tax reversion from the recent concessionary rate (0.8 per cent), the ongoing fiscal tightening of one per cent a year embodied in the debt ceiling agreement of a year ago, and the additional tightening of 1.25 to 1.5 per cent that was the “fallback” provision after the failure to come up with a bipartisan programme of extra cuts. The total is 3.5 per cent of GDP.
Wall Street and Mr Bernanke assume the politicians will be “rational” and not want a recession in the first part of next year; that they will therefore reduce this 3.5 per cent, perhaps even to nil.
Will politicians be “rational” and what is rational for politicians anyhow? Time is tight: the cliff will have to be renegotiated by President Barack Obama, who would remain in office until late January even if he lost, and by the current Congress, between election day on 6th November and Christmas. In addition, the US is projected to breach the legal limit for national debt once again at the end of the year—requiring further action by Congress.
But assuming the politicians are rational, what might they do? Given the need to cut another four per cent off the deficit, would it not be tactically sensible to make cuts now? Who wants to tighten policy just before the next election?
Rational politicians who want to limit US debt may find the cliff convenient. It was, after all, put into law by politicians to occur just after these November elections. But there is also a rational case that they would be wrong to limit the debt to 100 per cent of GDP. The slump in China and shambles in Europe has driven the cost of borrowing for the US, adjusted for inflation, down to minus 0.8 per cent for ten-year bonds, and to minus 1.6 per cent for five-year bonds. People are prepared to pay the US 0.8 per cent a year for ten years just to get their money back. Surely there are a couple of bridges to build out there, or roads to widen, that could yield a positive real return? In which case running the deficit yields a simple profit as well as creating jobs.
Against this lies the danger that very high US debt levels could make the country vulnerable to much higher interest rates later, to blackmail by major creditors such as China—or to imposing an unfair burden on future generations.
I lean to the second, cautious view: that the US needs to avoid debt levels now associated with Italy and Japan, let alone Greece, despite the advantages of its size and its reserve currency. But whichever way you feel on this conflict of objectives, and whichever way the cliff gets fixed, US policy makers have a healthier future economy to deal with than China, Japan or Europe.
It is hard to imagine Wall Street getting through the coming negotiations without taking a tumble. Our forecast is that when the dust settles, there will be 2-2.5 per cent of the cliff left, though some of it may be phased in over time. This could mean slow growth, maybe stagnation, in early 2013. But if that knocks some of the recent shine off US stocks, we could be looking at a generational buying opportunity.
