The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Sunday, June 10, 2012

You need to understand the risks associated with the US fiscal cliff and a recession in 2013

The exceptionally cerebral Russell Jones of Westpac has penned this excellent primer. Russell has been so relentlessly negative on the outlook for Europe--some might say wisely realistic--that I tend to push his work to the side and read it in batches when my stomach can bear it. Few people in Australia have heard or thought about the US fiscal cliff. But Russell is all over it. So here is something to sink your teeth into:

While global financial markets have latterly been consumed by Europe’s convulsions and uncertainties about China, the progress of the US economy has rather fallen off the radar screen. This is unlikely to be the case for long. The Presidential Election campaign is set to hot up over the course of the summer and the vexed issue of fiscal policy will increasingly both be at the centre of the political debate and the investment community’s concerns about 2013.

The US’s recovery has continued in unspectacular fashion so far this year, with growth currently running around trend. This might be a disappointing performance given the extraordinarily low level of interest rates across the entire maturity spectrum and relative to the usual experience following a deep recession, but it is viewed with envy by most of America’s OECD partners. What is more, beneath the surface there is tentative evidence of some important structural improvements: in short, a relatively rapid pace of household sector balance sheet repair; a turnaround in the housing market, which, of course, was at the epicentre of the Global Financial Crisis, and a greater willingness to lend on the part of the financial sector.

Sadly, however, it is too early to conclude that the US is on the cusp of a return to what we used to consider normality. Besides the threat of another traumatic negative shock emanating from Europe or the Far East, the US is confronted by an extended period of budgetary consolidation, the magnitude of which is on a par with that facing some of the more conspicuous Eurozone fiscal delinquents. What is more, the politics of addressing this issue remain extraordinarily complex and uncertain. The net result is that the risk is of an unduly austere fiscal stance in the period ahead that leaves the overwhelming burden of responsibility for stabilising the economy in the hands of a Federal Reserve that will necessarily not only have to fulfil its conditional commitment to keep the federal funds rate close to zero until the end of 2014, but launch a series of further unorthodox monetary policy initiatives, the effects of which are difficult to predict.

The US’s consolidated budget deficit is projected to be around 8.3% of GDP this year and the latest OECD Economic Outlook suggests that the economy requires a fiscal policy tightening (i.e. an improvement in its underlying cyclically adjusted balance) equivalent to some 6.5 percentage points of potential GDP to stabilise its gross debt ratio. But that stabilisation of outstanding liabilities would be in the region of 120% of GDP – i.e. the sort of debt ratio we have associated with Greece or Italy. Bringing the debt ratio back down to its pre-crisis level (67% of GDP) would require much more dramatic and extended fiscal policy surgery.

As things stand, existing legislation, which extends to the expiry of the 2001-03 Bush tax cuts, the payroll tax cut and the increased duration of unemployment benefits, together with automatic expenditure reductions equivalent to around ¾% of GDP, points to a total fiscal tightening of close to 4 percentage points of GDP in 2013. This would represent an aggressive front loading of the necessary fiscal adjustment. Indeed, it would be on a par with that instituted in Greece in 2011 and extremely difficult for the economy to digest. The net impact on economic output could prove devastating, especially when multiplier effects are taken into account. After all, according to the IMF, these tend to particularly significant when spending cuts dominate a fiscal adjustment programme, when households are facing liquidity constraints, when there is significant excess capacity, when a country’s major trading partners are also tightening fiscal policy and when monetary policy is at its limits. The US would appear to meet all of these criteria wholly or in some part. Not to put too fine a point on it, if fiscal policy is tightened by around 4 percentage points of GDP in the US next year, a return to recession is very likely.

The general market consensus at this stage is that such an intense period of fiscal austerity will not be allowed to occur. Essentially, Congress and whoever is occupying the White House next year will somehow reach an agreement to dilute the immediate budgetary adjustment and prevent the economy cascading over such a fiscal cliff. Clearly, one hopes that common sense will prevail, but given the extreme polarisation of the US political landscape, and in particular the “anti-Keynesian” philosophy running through the Republican Party and the obduracy of its “Tea Party” wing, this cannot be guaranteed. And even if policy-makers do manage to cobble together a less austere deal, that process will only begin in earnest at the end of November and given the experience of recent spats over the Debt Ceiling it is only likely to become reality after an extremely fractious and extended debate. There is therefore at the very least plenty of potential for financial market uncertainty and volatility around this issue. This is particularly the case as President Obama, who is according to the latest polls likely to remain President, is committed to the “Buffett Rule” and higher taxes on dividends and capital gains.

The lingering ambiguities over the US fiscal outlook are something of a double edged sword for the US Treasury market and global bond markets in general. The more fiscal policy is tightened, the more the Federal Reserve will have to seek to provide a monetary offset (even if the efficacy of that offset is questionable) and the more support US Treasuries will enjoy. On the other hand, should the new Administration and Congress fail to come to agreement on a credible consolidation path towards the restoration of fiscal sustainability, the danger is that the US could be sucked into the sovereign risk vortex. And that could push the entire global economy over the edge of a cliff.