I recall as I was about to leave work late afternoon on 5th August to head to Sheffield for a long overdue relaxation weekend hearing a rumor. The time was about 15:30 GMT/10:30am ET and the rumor was that when the US markets closed, rating agency S&P were to remove the beloved AAA from the US and replace it with AA+. We of course now know that this rumor did indeed turn out to be true, the US was downgraded. I learned a valuable lesson that day; listen to rumor at work. What on Earth has gone wrong with America though? In June 2011 the US economy managed only to create 18,000 jobs, something is seriously wrong here. The US economy was once the highest regarded and admired in the world. Indeed it was one to be almost envied from a European point of view, high growth, high employment and fundamental stability. Now though despite a huge stimulus both fiscal and monetary post the financial crisis it is still struggling. Where did it all “go wrong”?
In the 1990s, the US stock market and economy appeared to be soaring ever higher without any end. Of course we now know this wasn’t the case, following the falls on the stock market and economic slowdown in the late 90s (dotcom burst?), US policy makers in an attempt to keep the Uncle Sam’s head above the water, created conditions that would (arguably and very simply, of course when performing a serious analysis of the financial crisis, one cannot simply state low interest rates caused it) lead to the financial crises today. Interest rates were set at very low levels. The Bush tax cuts gave a huge boost to consumers but the cost would be an increase to the federal debt levels. Everybody seemed happy though, so why would government care? What is more critical and should be noted, is that the Bush administration, like Clintons, actively through government sponsored and funded programs (Freddie Mac and Fannie May anyone?) encouraged property ownership, supporting the growth of the sub-prime market (something that everybody now knows about of course for the wrong reasons). The technology bubble of the 1990s was quickly forgotten and confined to be a thing of the past. Meanwhile America became addicted to real estate. When this bubble eventually burst as they always do, policymakers tried the same fix as before. Interest rates were cut, the budget deficit expanded massively and the Federal Reserve did another round of quantitative easing. Yet despite all this, the US economy has simply refused to grow and recover.
The economic output today is similar to levels at the start of 2008, thus the economy has stagnated. The level of unemployment rate remains above 9% without any evidence to suggest that will change for the better at all soon, on the contrary, it looks likely to get worst. A time once existed where the US could happily and comfortably create up to 500,000 jobs per month. This is far from reality of present day America. A few years ago it was seen as somewhat of an economic fact by economists that the US economy would always grow in real terms around 3% p.a.; this as we know from economic history would be considerably ahead of the European average. Economists typically measure economic performance in the long run by looking beyond the cyclical ups and downs that inevitably (and always will) affect a nation's short term growth trends. One way this is undertaken is to look at economic growth figures on peak to peak basis although it can, and sometimes is, be achieved using the trough to trough part of an economic cycle. This method thereby enables a much more accurate look at economic activity at equivalent points across an economic cycle. By this method, growth through the Bush years and at the beginning of the Obama years slumped to roughly 2% p.a. By US historic standards this is poor. It looks even worse when comparing the figures to emerging economies growth rates now being achieved in places such as China, India and Brazil. In less than 4 years the US appears to have lost control. This is certainly the case in the light of recent data revisions which showed that the US economy hadn't grown as much as previously believed. It can now be factually claimed that the US has just been through both the deepest recession post World War 2, and more importantly, the worst post recession recovery. GDP is far lower than was assumed by government pre-crisis, unemployment is far higher and despite a massive monetary and fiscal policy stimulus, financial markets with good reason now fear a double-dip recession.
Larger American companies do have the money, this is an indisputable fact. Unfortunately for Uncle Sam they would rather save it. Those that do invest would much rather go to Asia or parts of South America. This leaves the typical American citizen with high levels of debt, whilst watching their home tumble in value.
The US government finds itself in the terrible position of having one of the biggest budget deficits in the world (in terms of share of GDP) and what seems to be an out of control government debt. The US budget deficit increased from 2.9% of GDP in 2007 to 10.6% in 2010. If we were to remove debt interest payments and make sensible adjustments for the economic cycle, the primary deficit rose from 1.5% to 7.0% of GDP (when having economic discussions with people, the amount who claim to have basic economic knowledge yet don’t know the difference between nominal, structural and primary deficit really does annoy me, sorry I had to include this). Just as worryingly, the gearing ratio of debt to GDP rose sharply from 62.0% to 93.6%.
Indeed as we know, things became so bad that the world was gripped with the terrifying possibility the US would default on its treasury bonds. Figures showed that America had to refinance the equivalent of 18% of GDP this year due to maturing debt, comparing that to the UK of 7%. People knew of course that a default wouldn’t happen, an eleven hour deal would be reached and indeed it was. Irrelevant of any deal though, it is indisputable that the present US budgetary position is a mess. With future growth more likely to average only 2%, a figure which is in line with the average of the last economic cycle so likely to be reality, rather than the 3% assumed by the Congressional Budget Office, the US budget post “compromise deal” will still be under intense pressure. The S&P downgrade merely formalises what everyone already knew. JP Morgan Chase believes that the downgrade is simply an inconvenience, but not much more than that. The symbolism of this downgrade and removing “prime investment” grade from the world’s largest economy is, however, tremendously important.
S&P's decision to downgrade US government debt reflects all of this but also, importantly, takes into account the “debate” (if it can be called that) in the run-up to the debt-ceiling extension. Even though policy makers agreed that the deficit needs to be brought under control (only an insane person wouldn’t), the differences of view about how this should be done could not be greater and indeed this became all too apparent when listening to the language of the discussions from both parties. The deal policy makers eventually reached leaves the US without any convincing control over spending. Thus a downgrade seemed the logical progression. The fact that the United States has been able to continue running at high borrowing for so long until now says a lot about the liquidity of America's financial markets, the worrying amount of safe havens in a world of financial uncertainty, the crisis in the euro countries and the foreign exchange reserve policies of the Chinese. America, after all, enjoys reserve currency status. You have to ask the important question, if the US were to default, where would all the buyers of US treasury bonds actually go? They can't all buy Swiss francs or Canadian Dollars (worth watching). For all the concern regarding sovereign debt, this is still a sellers' market with countries like China, Japan, Saudi Arabia and the UK still buying them. That is why the yield on US 10-year debt is still barely 3%. But are things about to change?
Already, the Chinese are demanding that America needs to cure its "debt addiction" or face the embarrassment of more downgrades. Given that the Chinese have lent so much to the Americans, it is worth noting that the US current account deficit is partly funded by China's current account surplus, how times have certainly changed. Guess which other country holds a lot of US debt so stands to lose? Of course it is the UK, though no way near the amount of the Chinese. It's easy to see why the Chinese are concerned though. To understand why, it's worth thinking about debt crisis else were in the world, let us go for Japan and Italy. Japan's position at first glance looks awful, worse than America's in fact. Government debt, has hit 200% of GDP. Italy gives a more positive first impression than America's. The Italian budget has by Western standards an impressive cyclically adjusted primary surplus, though debt levels are still high. When looking at borrowing costs though the story is a completely different matter. The Japanese government can borrow around 1% despite their fiscal weakness and high debt level while the Italians have to borrow at over 6% despite having lower debt levels as % of GDP relative to Japan and their apparent fiscal conservatism. The Americans, meanwhile, can borrow at around 2.5% despite all of the above problems. This does seems odd; however, Japan's government debt is mostly funded internally. Nearly 100% of Japanese Government Bonds are owned by the Japanese. There is no incentive to default because only the Japanese themselves would lose out. When Italy finds itself in fiscal difficulty, it either has to deliver unpopular austerity packages, default or negotiate a bailout from its European partners, who are hardly awash with cash themselves. The great German public are sick of seeing their government send billions of Euros down the drain to Greece and elsewhere. If neither austerity nor bailout is politically feasible, default is the only other option, shifting the burden from Italy's debtors to its – partly foreign – creditors. Hence yields are higher reflecting higher risk to foreign creditors.
What is of so much importance and must always be kept in mind is that the US has a printing press; therefore another round of quantitative easing could be an option for the administration. This fact is what is causing so much anxiety and worry in China. Printing more dollars helps shift the burden of adjustment away from domestic debtors to foreign creditors without the need for a formal default or a rise in bond yields. If the US prints more dollars, treasury yield will remain low (that is what QE does) but the dollar's value will decline on the foreign currency exchanges. Naturally this would produce a stronger renminbi, the Chinese currency (I must mention that I recall people in the past which I have had the displeasure of meeting who thought the Chinese currency was the “dung”). A higher renminbi value on FX exchanges will translate to a lower value of all those dollar assets purchased by the Chinese over the years to fund high US spending. The Chinese could attempt to counter this by also printing money in a bid to prevent the renminbi value from rising. The problem of cause with this counter method is inflation. Anybody though who follows Asian economies will know already that inflation in China already unacceptably high (printing money will make this worst), thus any action to increase inflation is not desirable and will create a whole package of further problems. So, if the US administration does peruse another go at quantitative easing, China loses. From the American point of view a weaker dollar benefits the US by improving its export competitiveness (indeed a weaker pound helped save Britain, a miracle we stayed out of the euro); a weaker dollar will mean cheaper US products on foreign markets and therefore increasing foreign demand for them. Higher exports will boost investment into the USA and bring with it private sector job creation which will facilitate a domestic economic recovery. Recovery through improved growth over an economic cycle in turn will lead to a higher GDP and hence lower the fiscal burden as a share of GDP. As I said though China looses, so I doubt this will happen quietly, if at all it is.
So where is the world going from all this, good news or bad news? According to research from banks there are two scenarios.
The good option is a treaty similar to the 1985 Plaza Accord except with the Chinese rather than Japanese. The Americans will need to reduce their budget deficit on an orderly basis, therefore reducing the volume of borrowing from the rest of the world. The Chinese agree to revalue the renminbi, something that they have resisted in the past as keeping the renminbi value artificially low helps keep Chinese goods cheap in European and American markets, though other factors are at play in 2011. A revalue of the renminbi will also reduce domestic Chinese inflationary pressures. The global balance of domestic demand moves towards the eastern emerging world away from the US (and Europe), the Chinese buy more of Chinese goods essentially. China agreeing to let its currency appreciate will of course put an inevitable squeeze on its exports, though this will be balanced by a domestic demand increase due to lower home inflation rates. Net global imbalances will therefore shrink. Simply everybody seems to win. This agreement though is a lot easier said than done, as so often things are. Right, so what else good happen?
In the worst case situation, the Chinese and others walk away from the dollar and dollar assets they have purchased before there is any agreement from the US to reduce its budget deficit. The Chinese informally declaring the intent to dump the dollar as the world’s reserve currency would be basically what they are doing here. With US creditors no longer willing to pay for America's borrowing habit, the US current federal account deficit has to and indeed must fall abruptly. A inevitable fall in the dollar helps, but critically doesn't do enough. The only way for the deficit to decline is through a fall in American domestic demand. In the absence of any government fiscal consolidation (evidence suggest this will be the case), only private demand can fall. Initially this is achieved through a rise in bond yields, but the rise in bond yields alongside a falling dollar ultimately leads to financial panic and thus will lead to a stock market collapse. A falling stock market will in turn lead to US investors to head for safety. They end up owning US government debt in the same way that the Japanese own their government debt but the cost is a period of incredible and damaging economic weakness.
Unfortunately rumors seem to be the latter……
Putting your seatbelt on, seat forward and tray in the upright position maybe a good course of action, we are entering an unknown world.
