Monday, 7 October 2013

We're Mad As Hell

Many of us will be experts in the dark arts of sequestration, whereby we create an ultimatum that will have future consequences.  At a personal level it might be “Give up smoking or I will leave you” or it might have a geopolitical significance “declare war on Serbia and we will declare war on you”.  Some of the most dangerous events in history have been triggered by intransigence enshrined in law.  The problem with sequestration is that is hardens attitudes and creates false deadlines and makes sensible negotiation all but impossible.
It may be that comparing one of the causes of the First World War with the current debt crisis in the US is somewhat melodramatic; but the important point is that a possible default by the US government has been conjured from a law that was meant to protect the US economy. 
Tea Party Slogan - reads badly in English!
In 2011, the Budget Control Act was passed as a tool for federal budget control. The act authorized an increase in the debt ceiling in exchange for $2.4 trillion in deficit reduction over the following ten years. In the event that the debt ceiling is breached a trigger mechanism in the bill activates to implement reductions in spending known as "sequestration".
The American people are pretty equally divided between those who think big government is likely to be a greater tyranny than a meltdown of the global economy and those who think spending can go on unabated.  US Treasury Secretary, Jacob Lew, has warned that the United States will default on its $16.7 trillion debt and throw the world into turmoil unless Congress agrees to raise the legal debt ceiling by October 17. “If the US government, for the first time in its history, chooses not to pay its bills on time, we will be in default,” said Mr Lew.   The government will have just $30bn by October 17, half what is needed to cover immediate needs over subsequent days. “That is a dangerously low level of cash, and we’re on the verge of going into a place we’ve never been. Even getting close to the line is dangerous,” he said.
So what is the danger for us in Europe?  At first sight this spat seems a typically domestic affair that will probably harm the US economy and will certainly harm the US Dollar’s reputation and role as the world’s reserve currency.  But will it really impact our real economy?  The first point is that it is still likely that there will be a fudge and that the deadline will be extended and the uncertainty will continue, but just suppose the brinkmanship goes wrong what might be the impact?
The first and most obvious problem will be with the Banks.  All global banks rely on the US dollar and US government securities as the best alternative to a global currency.  The global capital markets use US sovereign debt and US dollars as an interchangeable asset.  This asset is used to manage liquidity in the key markets.  For example, derivatives trading in currencies, fixed income, equities, credit and other asset classes, with notional outstanding values of $600tn,  are collateralized by US government securities.  If there was real doubt about the risks of default on these securities for even a day or two the whole banking sector would be at risk.
Secondly, the overall liquidity of the banks depend on the quality of assets they have at their disposal to back up the lending and investments they make.  If their main source of collateral were to be down-graded significantly they would have to find other sources of suitable collateral, this would create a credit crunch much worse than the 2008 tsunami that followed the Lehman’s collapse.   The resulting credit squeeze could then lead to creditor defaults (businesses going bust for lack of working capital) and possibly banking defaults.  The bad news is that Europe is highly exposed to this threat to our financial markets as the long awaited banking reforms are still a twinkle in the eye of Barroso and ECB.  Imagine the impact of a fresh banking crisis on, Portugal, Italy, Ireland, Greece and Spain (The PIIGS) – actually on second thought please don’t think about it might induce a panic that would finish them off anyway!
Another outcome would be high interest rates globally.  On a default the dollar would devalue the Fed would have to step in and raise interest rates and they rest of us would follow suit.  For all the forward guidance on QE and rates Bernanke would not be able to avoid increasing rates, causing further contraction in the US economy.  The combined effect of high interest rates and the sequestered cuts might see the US economy shrink by 5% next year – killing the party of the world economy.
The elephant in the room on all this is the gigantic scale of debt that the US government has run-up over the last few years,  US government debt now amounts to over 100% of their annual GDP, which is enormous as the size of the state is relatively small in the US compared to European economies.  With unemployment stubbornly high and growth incipient, it’s likely that these debts will not be reducing any time soon.  Obama seems to think that the American people will be prepared to fund these debts indefinitely and his focus on healthcare rather than on improving productivity – that will drive growth – is an elementary mistake.  There are some interesting parallels with the UK. In 1945 we were bust having thrown everything into the war against Hitler.  At the end of the war the then Labour government poured what money was left into nationalising key industries and the National Health Service.  In contrast Germany and France invested in productivity and over the next 35 years Britain lagged behind economically.  In 1980 the reverse happen and the UK chose to restructure whilst the rest of Europe went soft and over “invested” in welfare as a result we in the UK became the fastest growing economy in the West.  The US is at a similar crossroads, it’s just a shame that sequestration is destroying the debate and is putting the economy of the whole world at risk.


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