US Treasuries not safe, said don

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Don: US Treasuries not safe, emerging economies should find other ways to buffer themselvesImage via Wikipedia

JACKSON HOLE, Wyoming: Emerging economies should find other ways to buffer themselves from global crises than stockpiling US government debt, a prominent economist argued.

US Treasuries and the debt of other advanced nations might be liquid, but it was far from safe, Cornell University professor Eswar Prasad said in a paper presented to a group of central bankers gathered here.

Emerging countries seeking protection from global shocks by individually stocking up on US debt would be better off banding together to create a pool of funds that could be drawn on in a crisis, he argued. Doing so would give them a backstop should they need it, without saddling their national investment portfolios with debt that could turn sour.



Sharply rising levels of public borrowing and weak growth prospects in the United States mean that over time the dollar will continue to decline against the currencies of faster-growing emerging markets, eroding the value of emerging nations' foreign investments, he said. And the risks are not only for the long-term. The United States' near brush with default earlier this month, as lawmakers refused to raise the country's borrowing ceiling until a deficit-cutting deal was reached, brought the potential pitfalls of holding US debt into sharp relief.

“As demonstrated by recent events in the eurozone, bond investors both domestic and foreign can quickly turn against a vulnerable country with high debt levels, leaving the country little breathing room on fiscal tightening and precipitating a crisis,” Prasad wrote. “The US is large, special and central to global finance, but the tolerance of bond investors may have its limits.”

The dollar has long been the world's main reserve currency, and since the financial crisis emerging economies have built their reserves by buying Treasuries and the debt of a few other advanced economies, according to Prasad.

Any change could hurt the ability of the United States to borrow at low rates despite soaring debt levels.
That would turn the tables in a world where traditionally it was developed nations that pressured developing ones to bring their finances under control, he said.

“It is high time for advanced economies to take the tonic of macroeconomic and structural reforms that they have for so long dispensed to the emerging markets,” he said. Reuters

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US no longer ‘AAA’, Eurozone the next?

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US no longer ‘AAA’

WHAT ARE WE TO DO By TAN SRI LIN SEE-YAN

STANDARD & Poor's (S&P's) had on Aug 5 cut the US long-term credit rating by a notch to AA-plus (from AAA). This unprecedented move reflected concerns about the US's budget deficits and rising debt burden. It called the outlook “negative,” indicating that another downgrade is possible in the next 12-18 months.

According to S&P's, the Aug 2 debt deal which cut spending by US$2.1 trillion, didn't go far enough: “It's going to take a deal about twice the size to stabilise the debt to GDP ratio.” It also stressed what it saw as the inability of the US political establishment to commit to an adequate and credible debt reduction plan: “The effectiveness, stability & predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.” Moody's Investors Service and Fitch Ratings haven't followed S&P's move causing a split rating. They had earlier (on Aug 2) affirmed their AAA credit ratings for the US, while warning that downgrades were possible, grading the outlook as negative. At the same time, China's only rating agency (Dagong Global Credit Rating) downgraded the US from A-plus to A saying the deal won't solve underlying US debt problems.

US downgrade

What does a rating downgrade mean? For the US, it will affect its borrowing costs eventually and immediately, investor opinion of US assets. According to Sifma (a US securities industry trade group), the downgrade could add up to 0.7 of 1 percentage point to US Treasury yields, thereby increasing funding costs for US public debt by some US$100bil. But the US dollar has a special position as the numeraire of global transactions; it is also a reserve currency, and often regarded as a safe haven in times of uncertainty. Ironically, in the recent sell-off in equities world-wide following the S&P's downgrade, US government bonds was a big beneficiary. Its benchmark 10-year bond yields fell 21 basis points on Monday to 2.35%, the biggest one day drop since January 2009; by Wednesday, it was 2.14%, the lowest yield on record. Two year US Treasuries yield touched a record low of 0.23% and then, fell further to 0.184% on Wednesday. In the panic, Treasuries appear to be still the way to go.

With the downgrade, US no longer warrant the top-tier rating it enjoyed since 1941 (Moody has had a AAA on the US since 1917). At AA+, the US is still considered to have a “strong” ability to service its debt. Only Canada, Germany, France & UK still carry triple-A at S&P's. The downgrade didn't affect US short-term rating which remains at A-1+, the highest at S&P's. In a follow through, S&P's downgraded numerous government related enterprises (notably Fannie Mae and Freddie Mac which together hold more than one-half of US mortgages), 73 investment funds (fixed income funds, hedge funds, etc) and 10 insurance companies for their large holdings of Treasuries. But banks were spared on the implicit “too big to fail” policy of the government. Nevertheless, the US bond market retains widespread appeal. At more than US$35 trillion at end-March, this market is broad, liquid and deep. The Treasuries market alone has US$9.3 trillion debt outstanding. But in the end, the market decides. Consider Japan S&P's downgraded it in 2002. Today, Japan is still able to borrow freely & cheaply. As of Aug 9, interest rate on Japan's 10-year bonds stood at just 1.045% and 30-years, at below 2%. In practice, for the US, a double A-plus still works like a de facto triple-A.

Market rebound: Traders work on the floor of the New York Stock Exchange on Thursday — AP
 

Immediate global sell-off

When markets opened following the weekend downgrade, a global panic sell-off in equities took over.  There was a lot of fear and uncertainty in the markets, reflecting a confluence of three main factors:

● uncertainty about the US economy faltering, raising the risk of a double-dip recession;
● worries that the downgrade could further undermine US consumer confidence & business spending adding another layer of anxiety on the global economic outlook; and
● fear the euro-zone debt crisis will spin out of control, spooking investors.

All this took its toll. Stock markets plunged around the world with funds flowing into havens, such as gold (up 60% since 2010, surpassing US$1,800 a troy ounce), Swiss francs (up 24% against euro and 32% on US dollar over the past year) and ironically, US Treasuries. In Asia, markets closed at their lowest levels in about a year. Key benchmarks in Hong Kong, Seoul, Mumbai and Sydney skidded for the fifth consecutive day. Shares in China, Taiwan and South Korea plunged sharply before recovering some ground. All closed nearly 4% lower on Monday. In Hong Kong, the Hang Seng Index had its worst day since the 2008 financial crisis, falling another 5.6% on Tuesday; it had fallen by 16.7% in the past six sessions, or more than 20% from its recent peak. South Korea's Kospi was down 3.6% and Indonesia's main stock exchange fell 3%. At its close, the KL Bursa lost another 1.7% on Aug 9 (-1.8% on Aug 8). Japan's Nikkei fell 2.2% to its weakest level since the March earthquake. India's Bombay stock index declined 1.6%, its fifth drop in a row.

The Dow Jones Industrial Average (DJIA) recovered 1.5% on Tuesday after a record 635 point fall (-5.5%) in sell-offs on Monday. The German DAX closed further down 5% and the Paris CAC 4.7% lower while the FTSE 100 in London fell another 3.4%. The Stoxx Europe 600 index ended 1.4% higher following a 4.1% slide on Monday, although underlying sentiment remained extremely fragile. The VIX which tracks stock market volatility, reached its highest since the initial Greek debt crisis in May 2010. It rose 20% to 38.5 on Monday afternoon and then to 40.5 on Tuesday, reflecting extreme fear and emotional trading. It measures the price investors pay for protective options on the S&P's 500 index. After Monday's sharp share-price drop and the previous week's poor performance, China and Hong Kong aren't the only markets at or near bear territory. Stocks in Germany & France are now down more than 20% (definition of a bear market), from highs reached in the previous year. India's benchmark Bombay Sensex is down 20%, and Japan's Nikkei is off 16.5%.

A day after US stocks received a boost from the Fed to keep interest rates low until 2013, markets in the US and Europe resumed their plunge on Wednesday. The fear: politicians across the Atlantic won't be able to manage the significant headwinds buffeting the US & European economies. Woes were focused on France, where its bank stocks plunged amid worries it may lose its triple-A status. The Paris CAC-40 index fell 5.4%. In the US, the DJIA was down 4.62% (-520 points) wiping out Tuesday's surge. The Fed had run out of bullets. Asian stocks advanced Wednesday with sentiment helped by a strong Wall Street rebound. However, gains in most markets lacked the passion observed on the way down. Hong Kong was up 2.3%, South Korea, 0.3% and Taiwan, 3.3%. All three were still down more than 10% so far in August. Japan was up 1.1%, Australia, 2.6% and China, 0.9%. But Stoxx Europe 600 was down 3.7%. Expectations are for the markets to remain choppy. On Thursday, most Asian markets were back in negative territory. But Europe closed stronger (up about 3%) and the DJIA surged by 4% (+423 points).



European contagion 

Italy and Spain, the euro-zone's third and fourth largest economies, have a combined GDP of nearly 2.7 trillion euros, about 30% of the eurozone total. For nearly two years, the European Union (EU) has been trying to stem the unfolding debt crisis. The July 21 Greek bailout bought some time not much to ward off further contagion. The European Central Bank's (ECB) decision on Aug 7 to buy Italian and Spanish debt represents a watershed in EU's continuing battle against turning ECB into the lender of last resort. The ECB has insisted the main responsibility to act lies with national governments. Given worries of a new bout of contagion sweeping European and global markets, ECB defended the new intervention as restoring the “normal functioning of markets through a better transmission of monetary policy.” ECB's continued bond-buying brought benchmark Spanish borrowing costs for 10-year bonds down to 5.019% on Tuesday, close to their lows for the year. Italian 10-year bond yields also fell to a one month low of 5.143%. Both countries' yields had approached 6.5% last week a level that eventually escalated to push Greece, Ireland & Portugal into bail-outs. Analysts estimate ECB could have bought up to 10 billion euros, a small fraction relative to the size of Spain & Italy's debt markets. Italy's debt alone is 1.8 trillion euros.

Market sentiment aside, the purchases did little to change the fundamental backdrop in Europe where economic growth has slowed even in the “core” nations of Germany & France. Signs of stress remain despite the positive market reactions to ECB's decision. Deposits at ECB, for example, hit a 2011 high of 145 billion euros on Monday, reflecting banks' reluctance to lend inter-bank preferring the safety of ECB. There is a limit to how deeply ECB can be drawn into the fiscal misadventures of its members. Concerns are mounting on the French economy because of its high debt levels (85% of GDP, already above the US & rising) and weak growth prospects. Germany, in much better shape, isn't immune either. Already, the cost of insuring German bonds against default using credit-default swaps (CDSs) rose above 85 basis points, higher than insuring UK bonds for the first time on Tuesday, despite the London riots. There is growing concern the new austerity measures in Italy & Spain will slacken their struggling economies, plagued also by social unrest.

What's wrong with the US economy?

The recession ended two years ago. The stumbling recovery may turn out to be the worst ever. Most indicators are not reassuring unemployment at 9.1% is still too high and jobs creation too slow; GDP growth is faltering, income growth continues lagging behind; household wealth is falling; banks are not lending enough; and consumer expectations have not been positive. In the last eight recoveries, lost jobs were regained within two years of recession's end. This recovery is still seven million jobs below peak employment in 2008 and about two million fewer than if unemployment was held below 8%. The US economy will remain lacklustre for some years because of heavy household debt, a financial system deeply scared by mortgages, and a dysfunctional political establishment. Heavy household debt and a dismal job market have hurt consumers' confidence, further dampening their willingness to spend. The only bright spot is exports, reflecting the weak US dollar and still booming emerging economies. Unexpectedly, the pace of growth in US services fell in July to its lowest level since February 2010. Taken alongside disappointing manufacturing data, the services sector showed-up an economy with weak hopes of a rebound in the second half of this year, after an anaemic first half. According to Harvard's Martin Feldstein, “This economy is really balanced on the edge. There is now a 50% chance that we could slide into a new recession.” Even Prof Larry Summers now concedes: “The odds of the economy going back into recession are at least one in three.”

The US problem is more a job and growth deficit than an excessive budget deficit. The diagnosis of the run-up in debt out of control spending by the Federal government, is exaggerated. Indeed, the “cure” of severe spending cuts is likely to make recovery more difficult. The real problem lies in the fall-off in tax revenue. From 20% of GDP in 1998-2001, tax revenue has fallen steadily: averaging just 17% of GDP from 2002-08 and then, to below 15% in 2009-10. About 50% of the rise in deficit was due to the downturn because of “automatic stabilisers”, reflecting cyclical revenue falls and higher spending to assist the unemployed and other transfers to help the poor. They contribute to demand and assist to “stabilise” the economy.

The US rating downgrade is a warning bell. On present trend, its debt burden is unsustainable and the US political system seems unable to reverse it. To do so, it needs faster growth can't cut its way to growth. What's required is tax reform and a will to restore revenues back to the 20% of GDP trend; a prospect most Republicans have castigated. At issue is not the US government's capacity to service its debt, John Kay of the Financial Times pointed out. It is the “willingness of the government to repay.” If sovereign borrowers meet their obligations, it is only because “they want to.”

● Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching & promoting the public interest. Feedback is most welcome; email: starbizweek@thestar.com.my.

US downgrade spells more chaos; QE3 in the making; Time for US to stop blames, take responsibility!

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Downgrade spells more chaos

Global Trends By MARTIN KHOR

The US credit downgrade – coming after a weak solution to its debt ceiling crisis and signs of a new recession – is signalling greater turmoil ahead in the global economy.

LAST week was a tumultuous time for the global economy as stock markets plummeted on a series of bad news in the United States and Europe. But this may only be the start.

This week is likely to usher in even more turmoil as the prospects for recovery have suddenly turned negative.

After several other dramatic events, last week ended with the US’ credit rating losing its AAA status to AA+.

It was only one notch down, this downgrade was by only one (Standard and Poor’s) out of three rating agencies, and it had been half expected.

Nevertheless, it marks the end of an era. For the first time since 1917, the US does not enjoy an AAA rating.

It has long been assumed that the US dollar and its Treasury bills are the safest of havens.

There may be some practical effects of the downgrade as some funds which prefer or are allowed to only invest in AAA investments may have to find alternatives.

The US dollar is also expected to depreciate further, thus raising fresh questions about the role of the dollar in global trade and as the world’s reserve currency.

Manufacturers and traders are asking whether they should trade their goods in currencies other than the US dollar to avoid making losses.

This was shown in yesterday’s Sunday Star report on the reactions of Malaysian businessmen to the news of the downgrade.

The Federation of Malaysian Manufacturers’ president Tan Sri Mustafa Mansur urged Malaysians to consider trading in Chinese renminbi (as China is poised to be the world’s largest economy and a lot of Malaysia’s trade is with China) and in other currencies to avoid losses in export earnings from the continuing use of the US dollar.



Besides the use of the dollar as the main medium of exchange (the currency for global trade), it is also, by far, the world’s most important reserve currency, thus making it the global store of value.

Since almost all countries hold a major portion of their foreign reserves in US dollar assets (especially US Treasury bills), there has been increasing fears worldwide over the safety and value of their US investments.

First, there was the scare of possible default by the US Government in debt servicing, because of the White House-Democrats-Republican wrangling on the government’s debt ceiling.



On Aug 1, just a day before the deadline, a deal was struck in which the debt ceiling would be raised by US$2.1 trillion (RM6.32 trillion), provided the government slashes the same amount in its budget deficit over 10 years, with the bulk of how to do so to be decided by a bipartisan committee later.

This gives temporary respite, and the world will likely witness a repeat of the messy Washington budget conflict when the committee starts work.

As a caustic commentary in Xinhua news agency put it, the higher debt ceiling “failed to defuse Washington’s debt bomb for good, only delaying an immediate detonation by making the fuse an inch longer”.

Second, the S&P’s credit downgrade has articulated the fears of the investment and policy-making circles.

The confused and confusing atmosphere surrounding Washing­ton politics has seriously eroded confidence in the ability of the US to handle its budget, debt, fiscal, financial and economic policy issues.

Only political analysts who specialise in US politics can fully explain and anticipate the intricacies and implications of the views and tendencies of the various branches of the Republican Party (especially its Tea Party component and its effects on the Party’s congressional positions), the Democratic Party and the Administration.

But even non-specialists comprehend that there is a serious governance problem in the US which is affecting the rest of the world.

Its political system is experiencing a gridlock which will affect the US dollar, the US economy and the world economy’s prospects for what seems to be a long time to come.

Third, the US economy shows increasing signs of stalling leading to a new recession.

Last week’s indicators for consumer spending, manufacturing and services output were negative, and some prominent economists gave a 50:50 chance of a double dip recession.

Recession is made more likely by the inability of the Obama administration to take effective recession-busting measures.

Congress will block any new significant fiscal stimulus (as the debt ceiling crisis and solution show), while a new round of printing and injecting money through quantitative easing, which is being considered, may only have limited positive effects.

All these point to a further weakening of the US economy and the US currency, at least in the short term.
These three developments, all in one week, have galvanised those in business, trade, finance and policy making to re-think the role of the dollar and the US economy in the global economy.

In the short run, it is difficult to find alternatives to the dollar as a unit of exchange or as a store of value, mainly because the euro is in a crisis of its own, the Japanese economy faces its own difficulties and the Chinese currency is not convertible enough.

But many agree that in the long run, a solution or solutions must be found. Otherwise, the global trading and monetary systems could be in a disarray.

There is nothing like a crisis or an emergency to collapse a long run into a short run.

If the US and European crises continue to unfold without respite, the world is in for financial and economic turmoil similar to or even worse than the recent 2008-2009 great recession.

Solutions will therefore have to be urgently sought.

Smaller QE3 may be necessary to prevent US double dip recession

By YAP LENG KUEN  lengkuen@thestar.com.my

PETALING JAYA: With the US economy possibly sliding into a double dip recession soon, there are expectations of a third round of quantitative easing (QE3), which may involve smaller amounts.

“It is not a popular decision but may be the only reaction from the US Fed to keep the economy going,'' said Pong Teng Siew, head of research at Jupiter Securities.

“The Fed has limited options especially with no more government spending to stimulate the economy. Fiscal policy that involves government spending is out in the wake of arguments related to the US debt ceiling where the only acceptable solution to the Republicans is to cut spending, and not raise revenue.

“QE3 may involve smaller purchases of Treasury instruments at the longer end of the yield curve. This may help to drive down the yield where the medium term rates may also move down in tandem. In this way, interest costs may also be reduced.

 

“This time, there are less resources available, hence probably smaller amounts under QE3. Also, the market itself may reject larger amounts,'' said Pong.

There may be a resultant boost to the stock markets on a smaller scale. However, the European debt problem especially in Italy represents a situation that is likened to an elephant in a room.''

“As long as there are upward pressures in the Italian government bond yields, there will be downward pressure on the stock markets in Europe,'' said Pong, adding that investors should stay light on selected plantation, oil and gas and consumer-related companies.

Bloomberg reported on Friday that the difference in yield, or spread, between Italy's 10-year bond and German bunds widened to 389 basis points on Thursday, after closing at 368 basis points the previous day.

 Lee: ‘This time round, headline and core inflation have been creeping up.’

It said Spain's 10-year spread also rose six basis points to 398, as European Central Bank debt purchases failed to reassure investors that officials in the region would solve the sovereign crisis.

QE refers to the Fed's decision to buy US Treasury bonds in an attempt to inject liquidity into the market.

The previous rounds of QE1 and QE2 had not produced a lasting impact on the US economy which is holding the weight of inflation and higher debt levels.

CIMB Investment Bank head of economics Lee Heng Guie said full-year growth estimate for the US economy had been revised from 2%-3% to 1.5%-2%, raising the odds of a double dip recession by 30%.

Moreover, the cut in the US credit rating by Standard & Poor's would have a double whammy impact on the lethargic economic recovery in the US, Lee added.

In a recent update, Lee noted that the US second quarter real gross domestic product growth came in at a tepid annualised rate of 1.3%, short of the 1.8% consensus forecast.

Consumer spending in the United States, hurt by higher gasoline prices and auto chain supply disruptions, rose by only 0.1% (2.1% in Q1), the slowest in two years.

“We expect the Fed to take more actions, such as buying of bonds, if the economy appears in danger of stalling,'' said Lee.

However, he does not think that inflation and inflation expectations are heading towards the point which would prompt the Fed to consider further large asset purchases.

Lee recalled that before the second phase of quantitative easing (QE2) was implemented, the trend of disinflation and deflationary risk formed a strong case for the Fed to pump in extra liquidity.

“This time round, headline and core inflation have been creeping up,'' he said. “With inflation and unemployment rising at the same time, the Fed will find it difficult to justify yet another cash injection.''
Should the Fed detect firmer signs that the US economy is faltering, it may:

• Adjust forward guidance to push back timing expectations on the first rate hike.

• Shift back market expectations on when it will shrink its balance sheet. (In April, Fed chairman Ben Bernanke had signalled that the Fed may reinvest the proceeds from its bond purchase when they mature).

•  Intervene in the credit market through direct loans or adjust interest rates payable on bank reserves to spur bank lending.

 Other economists expect slower growth in the United States but not necessarily recession.

A banker told StarBiz that banks in general were adopting a cautious stance in view of the world and eurozone economic conditions.

“The US leaders have mainly taken temporary measures but the real issues like debt are not addressed,'' he said. “The debt problem remains while their agreements have to be bipartisan.

“From their behaviour, there seems to be a lot of politicking in the US especially on the economy. As a world leader, that does not give a good picture to the whole world.

Their decision to cut US$2.4 trillion or more in spending in ten years will have an impact on the world economy. Hopefully, for Malaysia, the economic transformation projects and its own economic growth will provide the momentum forward.

“The business is there but banks have turned cautious on lending and are diversifying into services, fee-based income, niche areas and wealth management,'' said the banker.

 Commentary: It's time for U.S. to stop blames, take responsibility

(Xinhua)

The White House on Saturday challenged the ruling by Standard & Poor's to downgrade U.S. long- term credit rating form top rank of AAA to AA+, citing the agency' s decision relied on faulty math and in haste.

Disappointingly, instead of reflecting on themselves and sitting down to fix problems in a cooperated way, the Democrats and Republicans in Washington are questioning the creditability of the downgrade ruling and blaming each other for the ever-first shame of slipping out top credit rating club.

During the angry finger-pointing, the U.S. politicians seemed to have forgotten Wall Street's severest losses in almost three years last week, forgotten mounting concerns about double-dip recession, and forgotten the criticism over their irresponsibility showed during the debt arm-twisting from all over the world.

The world has seen enough useless bipartisan debate. The bond- holders are losing confidence. The investors have started to escape markets to stay in cash, showing their fears of uncertainty.

S&P managing director John Chambers said "The political gridlock in Washington leads us to conclude that policymakers don' t have the ability to put the public finances of the U.S. on a sustainable footing ".

The alarm has rung. It is time for the naughty boys in Washington to stop chicken games before they cause more damages. It is time for the policy-makers in Washington to settle down, to show some sense of responsibility and fix their fiscal problems.

The United States is not only the biggest debtor, who must pay its large amount of obligations, but also the printer of international reserve currency, which has the responsibility to assure the value of other countries' foreign reserve assets.

If the country's governors kept wrangling for their own interest, ignoring the voices from domestic and aboard, how can their people trust them and where will the confidence for a better economic scenario come from?

If the world's largest debtor kept eating May's grain in April and kept robbing Peter to pay Paul without fiscal discipline, eagerness to balance budget or effective efforts to boost sluggish economy, how can the creditors keep lending without doubts?

According to analysts, risk of dollar devaluation increased after this downgrade, not to speak of the possibility to see more cuts in the next two years with a negative credit rating outlook.

Whether admitted or not, the U.S. central bank tended to maintain a cheap dollar for the export's sake aftermath the financial crisis, which already squeezed world foreign reserves.

Currently, the U.S. is facing a high unemployment rate of 9.1 percent and almost stalled economic growth. But the Federal Reserve's "silver bullets" have run out after two round of quantitative easing. For fiscal stimulus, there is only little room considering the excessive debt and austerity agreement. For the desperate policymakers, to boost export seems to be the last way to kick the U.S. economy. From this point, the U.S. has every motive to maintain a weak dollar.

Before the U.S. makes any move, please remind it: don't forget your responsibility as the issuer of reserve currency to maintain the stable value of the dollar. Don't become blind to the great risks that a fluctuated exchange rate could pose to international financial markets and a weak greenback could pose to the world fragile economic recovery by lifting dollar-denominated commodities prices.

The history is a guide. What we should learn from the financial crisis is to be selfish could only hurt yourself and drag others into water.

It is time for the U.S. to tighten belts and solve structural problems, in order to resume reputation and restore world confidence. 

 Latest US and global market and business news, pictures and videos from AP-Wire  

Washington and the Art of the Possible

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Raghuram Rajan

CHICAGO – These days, the United States media are full of ordinary Americans venting their rage at the incompetence and immaturity of their politicians. Even though the US government’s debt limit was raised in the nick of time, the process was – and remains – fraught with risk. Why, the public asks, can’t politicians sit down together like sensible adults and come up with a timely agreement that commands broad consensus? If we can balance our household budgets, they ask irately, why can’t our political leaders?

The reality, though, is that US politicians reflect the views of the American electorate – views that are fundamentally inconsistent. The absence of broad consensus is no wonder. Indeed, the last-minute agreement to raise the debt ceiling is proof that the politicians did what they were sent to Washington to do: represent their constituencies and only compromise in the interests of the country as a whole.

The key question is whether the political gridlock exposed by the debt-ceiling debate will worsen in the run-up to the 2012 presidential and congressional elections – if not beyond. That is possible, but we should not overlook cause for hope in what America’s politicians just accomplished.

Let’s start with why the electorate is so polarized. There are two key divisive factors: income and age. Income inequality has been growing in the US over the last three decades, largely because the labor market has increasingly demanded skills that the education system has been unable to supply. The everyday consequence for the middle class is a stagnant paycheck and growing employment insecurity, as the old economy of well-paying low-skilled jobs with good benefits withers away.



Until the financial crisis, the easy availability of credit, especially against home equity, enabled the middle class to sustain higher consumption despite stagnant incomes. With the collapse of the housing bubble, many people lost their jobs and health insurance, risked losing their homes, and suddenly had little reason for economic optimism. The response from America’s Democratic Party, which has traditionally represented this constituency, was to promise affordable universal health care and more education spending, while also protecting government jobs and entitlement programs.

When added up, such spending is unaffordable, especially with current federal revenues at just 15% of GDP. The solution for many Democrats is to raise revenues by taxing the rich. But the rich are not the idle rich of the past; they are the working rich. To balance the budget only by taxing the rich will require a significant increase in income taxes, to the point that it would lower incentives for work and entrepreneurial activity considerably.

This is not to say that taxes on the rich cannot be increased at all; but such increases cannot be the primary way of balancing the budget. Republicans, trying to give voice to many working Americans’ ambient uneasiness with rising government expenditures, as well as to the growing anger of the working rich, find it easier to defend a principle than a particular constituency. Hence their mantra: no additional taxes.

The neat divide based on income is muddled by the elderly. It is understandable that older Americans who have few savings want to protect their Social Security and Medicare benefits. However, even elderly Tea Party Republicans, who are typically against big government, defend these programs because they view them as a form of property right, paid for when they worked.

In truth, rising life expectancy and growing health-care costs mean that today’s elderly have contributed only a fraction of what they expect to receive from Social Security and Medicare. The government made a mistake in the past by not raising taxes to finance these programs or reducing the benefits that they promised. Unless the growth of these entitlement programs is curbed now, today’s young will pay dearly for that mistake, in the form of higher taxes now and lower benefits when they are old.

But the elderly are politically active and powerful. Not only do many defend their entitlements strongly; some oppose growth in other types of public spending for fear that it will weaken the government’s ability to pay for the benefits that they believe they are owed.

These then are the roots of America fiscal impasse, which has produced passionate constituencies viscerally opposed to compromise. Any political deal significantly before the debt-ceiling deadline would have exposed politicians to charges of betrayal from their constituents. And, given that President Barack Obama would ultimately be held responsible for a default, he needed the deal more than the Republicans did. So he had to coerce his party into accepting a deal full of spending cuts and devoid of tax increases.

Will the deal deliver what it promises? A bipartisan committee has to propose $1.5 trillion in deficit reduction by the end of this year, and Congress must either accept that proposal, or see immediate, politically painful expenditure cuts, which would include defense spending – an area that America’s Republicans care about strongly.

If this structure works as advertised, Congress will be forced to reach a compromise, which can be sold once again by politicians to their polarized constituencies as being necessary to avoid a worse outcome. This time, Obama’s Democrats will be on a level playing field, because both parties will be held equally responsible for a failure to reach a deal.

Ultimately, the big necessary decisions on curbing entitlement growth and reforming the tax code will probably have to wait until after the next election, giving the divided electorate an opportunity to reflect on its own inconsistency and send a clearer message. In the meantime, US politicians might have done just about enough to convince debt markets that America’s credit is still good. For that, Americans – and others around the world – should stop pillorying them and give them their due credit.

Raghuram Rajan, a former chief economist of the IMF, is Professor of Finance at the University of Chicago’s Booth School of Business and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy, the Financial Times Business Book of the Year.

US debt ceiling: Senate rejects Republican 'cut, cap and balance' bill

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Senate rejects Republican 'cut, cap and balance' bill

 

 "If we don't solve it, every American will suffer," Mr Obama said of the debt ceiling debate

The Democratic-led US Senate has rejected a "cut, cap and balance" bill passed by the Republican-led House.

The bill would have severely cut public spending and forced the government to balance its budget.

 The move highlights divisions within Congress as a deadline nears to raise the US debt limit, analysts say.

On Friday, House of Representatives Speaker John Boehner said a deal to avoid a possible default on 2 August was "not close".

'No agreement'

Republicans and Democrats appeared on Friday to harden their respective positions over the debt issue.

Mr Boehner was quick to quash reports that he was close to hammering out a deal with President Barack Obama.

What happens if US defaults?

Uncharted territory but two scenarios emerge
Worst case:

• Higher interest rates on mortgages, credit cards and loans
• Government unable to pay wages to staff, including military
• Social security cheques stopped
• Turmoil on international markets

Better case:

• Default could be avoided by paying creditors, at expense of slashing spending

Sources: Associated Press, CBS, ABC

"There was no agreement, publicly [or] privately, never an agreement and frankly not close to an agreement," Mr Boehner, a Republican, told reporters following a private meeting with House Republicans.

Meanwhile, Senate Democrats complained they had been left out of negotiations, with some warning the president against an agreement that would disproportionately burden the poor by exacting big cuts to social programmes.

In a town hall-style meeting with voters in Maryland on Friday, President Obama warned that every American would feel the economic pain if Congress failed to reach an agreement to raise the US debt limit.

"If we don't solve it, every American will suffer," he said. "Businesses will be less likely to invest and hire in America. Interest rates will rise for people who need money to buy a home or a car, or go to college."

The US national debt is currently about $14.3tn (£8.8tr), fed by an annual government budget deficit that reached $1.5tr this year.

The US government's authority to borrow money is limited by statute.

Historically, Congress has raised that debt limit as a matter of routine, but this year, the Republican party - buoyed by a group of newly elected hardline fiscal conservatives in the House of Representatives - has demanded steep cuts to the US budget as the price of an increase.

Who owns the $14.3tn debt?

• US government owes itself $4.6tn
• Remaining $9.7tn owed to investors
• They include banks, pension funds, individual investors, and state/local/foreign governments
• China: $1.16tn, Japan: $0.91tn, UK: $0.35tn
• Deficit is annual difference between spending and revenue, $1.29tn in 2010
• Congress has voted to raise the US debt limit 10 times since 2001

Source: US Treasury, May 2011, Congressional Research Service, Congressional Budget Office

The Obama administration has warned the US risks defaulting on its debt if Congress does not raise the limit by 2 August.

In recent weeks, Republican and Democratic congressional leaders have worked with the White House to devise an agreement that would raise the limit while trimming the budget deficit, but the talks have collapsed several times.

Republicans have fiercely resisted Democratic proposals to raise additional tax revenue by closing tax loopholes that Democrats say primarily benefit the wealthy, while Democrats have vowed to protect social programmes for the elderly and poor from Republican-proposed cut backs.

In recent weeks, the White House and a bipartisan "gang of six" senators have floated proposals to trim trillions of dollars over the next decade.

The plans would cut the deficit through a mix of spending cuts and tax increases, but hardline conservative Republicans in the House of Representatives have urged Republican leaders to reject those.

Meanwhile, Senate Democratic and Republican leaders are crafting a fall-back plan that would enable Mr Obama to raise the debt ceiling unilaterally.

The Republican-led House of Representatives approved the "cut, cap and balance" plan on Tuesday of this week.

It would have reduced government spending by cut spending by $5.8tr over 10 years, capped future government spending at a certain percentage of the US economy, and amended the US constitution to require a balanced budget.

Mr Obama vowed to veto the bill, and the Democratic-led Senate on Friday rejected it, saying it would bring about steep cuts in social programmes.

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US debt impasse a global issue

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GLOBAL TRENDS By MARTIN KHOR

The political deadlock in Washington on whether and how to increase the United States’ debt limit is causing anxiety over a possible default and the consequent global economic downturn.

 

A Chinese 100 yuan banknote is placed under a $100 banknote. (Petar Kujundzic/Courtesy Reuters

THE deepening of the Eurozone debt crisis last week through contagion, spreading to Italy, was more than matched by the growing chance that the US government would not be able to pay its bills or service its debts starting Aug 2.

Week-long negotiations took place between US President Barack Obama, and the Democrat and Republican party leaders to avert a partial closing down of the federal government.

The US currently has a limit to its federal debt of US$14.29tril. This limit will be reached by Aug 2.

Congress has to approve raising this limit before then, or else the Administration will have to postpone meeting some of its financial commitments.

Federal Reserve chairman Ben Bernanke warned that default would send shockwaves throughout the global economy.

The alarm bells rang even louder when two rating agencies, Moody’s and Standard and Poor, warned they might downgrade US debt from its AAA status if the political impasse continues.

There are several reasons why the world, and especially the developing countries, should be alarmed at this situation.

First, many developing countries hold many billions of dollars of US Treasury bills as part of their foreign reserves.

An actual default raises the unthinkable prospect of the countries having to take a haircut, being only paid back a part of their bonds. This is unlikely to happen.

But even the prospect of default and a credit status downgrade would reduce the value of their bonds. Moreover the recent decline of the dollar’s value will likely accelerate, causing further losses.

Last week, China (which holds US$1.15tril in Treasury bonds) called on the United States to adopt responsible policies and measures to protect investors of US bonds.

Second, economic growth in the developing economies will be hit if the standoff or the eventual solution causes the US economy to move to a standstill or a new recession.

Whatever the final deal between the President and the two Parties, its centrepiece is certain to be deep cuts in government spending. This will reduce effective demand in the economy.

The effect will be opposite to the Obama administration’s recession-busting fiscal stimulus that enabled the economy to bounce back after the 2008-09 recession.

Third, the uncertainties in Washington emphasise the present unhealthy dependence on the US dollar as the international reserve currency.

The need for reform to reduce this dependence on a single currency, for example, by greater use of the special drawing rights (a basket of major currencies) as a global reserve currency, has been advocated by several prominent economists such as Joseph Stiglitz, Jose Antonio Ocampo and Yilmaz Akyuz as well as policy makers such as the Governor of the Chinese Central Bank.

A default in servicing US debt has moved from the unthinkable to the possible, though still in the realm of most unlikely. It may reignite the debate on reform of the global reserve system.

The facts of the impasse in Washington are as follows.

The current debt limit of US$14.29tril is forecast to be reached on Aug 2, so no new loans are allowed after that.

The administration estimates that the debt limit has to be increased by US$2.4tril so that the govern­ment can meet its commitments up to November 2012, after the Presidential elections.

Many Republicans in Congress, especially those under the influence of the Tea Party group, want the government to achieve budget balance through slashing spending without any increase in taxes, and to achieve budget balance.

A few Republican leaders, however, are willing to consider a small increase in taxes, or rather in closing tax loopholes, but they are finding difficulty in convincing their colleagues. They also want spending cuts to exceed the rise in the debt limit.

The President and Democrats are willing to cut spending significantly, but want also to raise taxes of the rich, so that both can contribute to the deficit reduction.

Democrat leaders are adamant that social and medical security should not be affected by the cuts, though Obama is willing to allow some cuts there as well.

If the extreme stance of the Tea Party faction becomes the overall Republican line as well, a deal would be extremely difficult.

To meet it, the Democrats and President would have to move their compromise position to the degree of total capitulation.

If the deadlock continues, a possible solution may be the proposal of Senate Minority Leader Mitch McConnell: the president submits his plan to increase the debt limit and to cut the budget, the Congress rejects it, the President vetoes the rejection, and his proposal is adopted unless two-thirds of Congress rejects it again.

This will allows all sides to claim that they stuck to their positions, while avoiding a crisis.
If there is still no agreement by Aug 2, then the administration will have to choose which items not to pay and when.

These include interest on Treasury bills, social security, medicare, defence vendors, unemployment benefits, food stamps, military pay, federal salaries.

Priority will be given to debt servicing, so a default on Treasuries is very unlikely unless the impasse lasts a long time.

The other services and salaries will be hit, and increasingly so as long as there is no deal.

As almost everyone will agree, this is no way to run a government, and the US governance system is becoming dysfunctional.

This has serious effects on the rest of the world. So the universal hope is that some solution will be found before Aug 2.

Global Unease on U.S. Debt Impasse

By Jonathan Masters, Associate Staff Writer

With the deadline for a U.S. credit default less than three weeks away, President Barack Obama and top Republican lawmakers remain at odds over a deficit reduction plan that both sides view as a prerequisite to any hike in the debt limit. The impasse continues to fuel apprehension within the global financial system, with two of the "Big Three" credit rating agencies--Moody's and Standard and Poor's--considering downgrading the United States (WSJ) from its AAA status. Moody's cited the "rising possibility" the U.S. debt limit will not be raised in time to avoid default. Economists warn that a significant loss of confidence in the U.S. debt market could prompt foreign creditors to unload large portions of their holdings, sparking a sharp increase in U.S. borrowing costs and calling into question the dollar's role as the world's reserve currency.


Most economists agree that the impact of an outright government default would be severe. Federal Reserve Chairman Benjamin Bernanke has warned a default would usher in a new financial crisis. While some suggest the market still assumes the issue will be resolved, they say a default would do unprecedented injury to the full faith and credit of the United States and roil international markets (DowJones) in a sea of uncertainty.

China, the largest U.S. creditor, has reiterated its call for a swift compromise in the debt talks. Beijing would be particularly exposed to any acute shock to the bond market, with about 70 percent of its $3.2 trillion foreign exchange reserves invested in U.S. Treasuries (Reuters). Historically, the U.S. debt market has been driven by huge investments from surplus countries like China, which have viewed the United States as the safest place to store their savings.

The Economist notes that while a default may not precipitate an immediate sell-off by foreign banks due to a lack of immediate alternatives, the event would discourage future holdings of such magnitude. As the largest economy and home to the world's reserve currency, the United States has traditionally attracted investors looking for a financial safe haven. But some analysts suggest the current fiscal crisis, including the threat of default, could accelerate a shift in the way global capital is allocated (TIME)--away from developed nations like the United States and Japan and into emerging markets such as China and India. The Wall Street Journal reports that in addition to China, investors in Japan, Russia, and a number of Persian Gulf states will increasingly look for alternative investments to diversify their sovereign holdings.


Bill Gross of the investment management firm Pimco writes that global investment managers are keen to punish defaulting countries (WashPost) severely, adding that alternatives like Canada and Germany are only a wire transfer away. He says a default may prompt foreign banks to rethink their currency preferences, jeopardizing the reserve status of the dollar. A 2010 survey by the McKinsey Global Institute found fewer than 20 percent of business executives surveyed expected the dollar to be the dominant global reserve currency by 2025. However, with a systemic debt crisis racking Europe, some analysts claim there is still no viable alternative to the dollar (DowJones) in the short to medium term.


But an impression of eroding U.S. power is already gaining traction. The latest Pew Global Attitudes poll finds: "In fifteen of twenty-two nations, the balance of opinion is that China either will replace or already has replaced the United States as the world's leading superpower." The poll says the "United States is increasingly seen as trailing China economically."

Selected Analysis:

The United States has entered its "own age of austerity," with the solution to country's fiscal woes coming only through long-term spending reductions, particularly in entitlement programs, writes Mort Zuckerman in the Financial Times.

A period of austerity brought on by debt mistakes will have "profound consequences, not just for Americans' standard of living but also for U.S. foreign policy and the coming era of international relations," write CFR President Richard N. Haass and former Deputy Treasury Secretary Roger C. Altman in Foreign Affairs.

This report from the Brookings Institution addresses the nature and quality of U.S. political leadership, the sources of the nation's governance problems, and some strategies to work around them.

The New America Foundation's Maya MacGuineas recommends an immediate increase in the debt ceiling and the negotiation of big budget deal ($4 trillion) that will keep the nation's debt from outpacing the economy.

Weigh in on this issue by emailing CFR.org.