Monday, November 12, 2012
World cannot afford second Fiscal Cliff after Europe’s failed attempt
It is a solemn oath to the American people -- under pain of political perjury -- crafted by my old friend Grover Norquist to block retreat.
Each member of the covenant vows to “oppose any and all efforts to increase the marginal income tax rate for individuals and business; and two, oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates”.
Mr Norquist can legitimately argue that the US elections have reinforced the mandate of those demanding radical action to shrink the Leviathan state. The Republicans held the House -- the paramount budgetary institution -- by a fat majority on a crystal clear message. The party will now hold 30 governorships, the highest in twelve years.
You can see why they might feel justified in digging in their heels, if necessary letting the nation go over the fiscal cliff at the end of the year. Taxes would go up, but not with their fingerprints on the legislation. The White House could be blamed.
The story is by now well-known. Unless there is a deal in Congress by the end of the year, the Bush-era tax cuts and the payroll cuts will reverse automatically; extended jobless benefits for the long-term unemployed will be cut off; defence spending will be cut; so on. Everybody’s sacred cow is sacrificed. The combined austerity would be around $700bn over 2013, or 4.5pc of GDP.
At the other end of Pennsylvania Avenue, President Obama can claim with equal or greater authority that he has the higher mandate to reshape the country, and he shows little sign of yielding. “We can’t just cut our way to prosperity. We have to combine specific cuts with revenue, and this means asking the wealthiest to pay a little more in taxes,” he said.
“On Tuesday night we found out that a majority of Americans agree with my approach. Our job now is to get a majority in Congress to reflect the will of the American people. I’m open to compromise. I’m open to new ideas. I’m committed to solving our fiscal challenges. But I refuse to accept any approach that isn’t balanced. I am not going to ask students and seniors and middle-class families to pay down the entire deficit while people like me, making over $250,000, aren’t asked to pay a dime more in taxes,” he said.
This will go to the wire, and perhaps beyond. It has all the makings of a colossal debacle for America and the world.
It is why the International Monetary Fund has elevated the fiscal cliff to a “medium probability event”. The Fund fears a very nasty “feedback loop” at this delicate juncture that could tip the global economy into a second leg of the Long Slump, with “deep recession in the euro area periphery” that would test political and social systems to breaking point.
We are already beginning to pick up warning signs in the credit markets from rising Euribor-OIS spreads, the risk gauge for European banks trying to raise dollar funding.
Mark Cliffe from ING said the fiscal battle may prove the catalyst that sets off another spasm of the EMU debt crisis, ending the fragile “political truce” of the last three months in Europe - where the credit crunch is grinding deeper and recession is at last engulfing the core. The effects would ricochet back across the Atlantic.
The fiscal cliff is not an either/or outcome. Bank of America said a compromise of 2pc or 3pc tightening is possible, or even likely. With the economy so far tracking an annual growth rate of barely 1.5pc in the fourth quarter - near stall speed - this alone could be enough to trigger the downward slide.
To those who argue that a fiscal shock is exactly what is needed to force Washington to get a grip, the answer is that such a policy is being enacted with painfully unhappy results in front of our eyes in large parts of Europe. It is causing the overall debt burden to rise -- not fall.
(Graph from IMF report)
This is in stark contrast to the US where Americans are cutting their debt burden at the fastest rate in over half a century. The public debt to GDP ratio is rising, but private ratios are falling. Combined debt - the figure that really matters - has dropped from a bubble peak of 373pc of GDP to 336pc this year.
This can be exaggerated. Some of this is “financial debt”, easily cut as banks pull back from global over-reach. The underlying US debt remains shockingly high, at least 100pc of GDP above historical trend. Yet there is clearly no headlong lurch into a debt-compound trap.
Citizens have slashed debt by $1trn, partly by defaulting on mortgages. The states and cities have retrenched drastically, cutting liabilities by nearly $100bn in absolute terms. Washington has been leisurely, of course, but the “cyclically adjusted” deficit has nevertheless been cut from 8.7pc to 6.8pc over the last two years, according to the IMF’s Fiscal Monitor.
Arguably, this is the right pace, the therapeutic dose of 1pc net tightening each year. It is what a grown-up nation with its own currency should do in a “balance sheet” slump when the private sector is deleveraging year after year. To do otherwise is to forget the lessons of the 1930s. As the IMF keeps telling us, it is a marathon not a sprint.
The rest has been achieved by keeping the economy above water, deploying monetary stimulus a l’outrance to avert a double-dip recession - the killer for debt-trajectories - and letting growth slowly heal the wounds. America’s output has comfortably surpassed the previous bubble peak. That makes all the difference.
Ray Dalio from Bridgewater Associates calls it a “beautiful deleveraging”, part austerity, part write-offs, and part money creation to erode debt costs gently and head off debt-deflation. America’s public debt has of course vaulted from 76pc of GDP at the outset of the crisis to 107pc this year (IMF data), comparable to damage from a world war, but that is a debt rotation effect.
To those who wish to let the fiscal cliff run its course, one can only caution that Europe offers us the grim lesson of what happens if you go down that route, even if is not a “pure” experiment.
We don’t know whether tough austerity would have worked if it had been offset by loose money. It was never tried. The European Central Bank has been too tight ever since its Magnum Erratum in 2008, and is currently allowing the money supply to contract again (month-on-month).
The South is facing violent fiscal austerity without anaesthesia. The result in Greece has been an explosion in debt ratios as the economic base collapsed. But lesser variants have occurred across the Arc of Depression, with disturbing results that they are entering a similar vortex as austerity bites in earnest. In technical terms, it is what happens if nominal GDP grows more slowly than the debt stock.
Spain has gained remarkably little from its austerity so far. The budget deficit will end this year at 8pc, modestly down from 11.2pc in 2009. (The US has gone from 13.3pc to 8.7pc). In the meantime, companies and banks are spiralling deeper into trouble as bad debts rise, feeding the vicious circle that comes back to bite the state. This is looking very Grecian.
Europe’s austerity lords insist that Italy, Spain, Portugal, Greece, and others are grasping the nettle of reform and will emerge from the crisis lean and fit. Perhaps they are right. But the counter-argument is that Euroland’s real problem is unemployment - already 25.8pc in Spain, 25.1pc in Greece, 15.7pc in Portugal, 15.1pc in Ireland, and 11.6pc in the eurozone as a whole - and this has been made far worse by contractionary policies.
The youth jobless rate is 58pc in Greece, 54.2pc in Spain, 35.1pc in Italy, and 25.7pc in France.
Labour economist and Nobel laureate Peter Diamond says the life trajectory of these young people will be damaged. There is almost nothing worse you can do to the productive potential of an economy - and therefore to debt ratios - than locking a great chunk of the future workforce out of the system during their formative years.
“They have a debt problem and an unemployment crisis, but they think it is the other way round,” he said.
The tragedy is that Europe is wasting its last chance to train a workforce for the 21st Century before its demographic crunch hits later this decade. EMU leaders - like the donkey generals of the trenches - are fighting the wrong war. They are crippling a generation. Budget deficits are coming down - though far less than assumed - but the skills deficit of the jobless army is going through the roof. It is the tyranny of the Maastricht Treaty.
It would be a double tragedy if the US succumbed debt fetishism and made the same historic misjudgement.