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.
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". Tea Party Slogan - reads badly in English! |
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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