Wednesday, July 27, 2011

US Debt War Will Lead To Recession

Hate to say it folks but there's about a snowball's chance in hell that the world won't have returned to recession by the end of this year. There are many factors involved that make this likely - the necessary slowing of China's growth, the defaults and austerity packages rolling around the south of Europe and the UK, the lack of any life in the North American economy. But it's also certain that the US debt situation has cemented that inevitability.

The irony of the hullaballoo between Obama and the Democrats on one side and those zany Republicans on the other is that it has focused the attention of everyone in the USA - not to mention the planet - on the fact that America is choking on debt. Being America, which recoils from government spending, other than enormous and wasteful military budgets, like Dracula recoils from garlic, the obsession is with government debt, rather than total debt. But that is another story. It is unlikely that anyone in the USA, by the end of this Gong Show, will think that the US economic or political system is stable.

The fear of instability is a self-feeding depressant when it comes to consumer spending and investment, especially when the vast majority of the population already feel that their incomes and investments in things like houses are unstable. Of course, the Republican demand that the Debt Ceiling Cage Match do a quick lap before returning early next year for a second round will only exacerbate the instability effect. But, then, from the point of view of the reality-challenged Tea Party, it will be an excellent opportunity to have an issue that they love - government taxation and expenditure – with which to beat Obama as he heads for re-election.

But instability fears aside, there are less ephemeral reasons to expect that the economy is going to take the off ramp to Downersville no matter what the ultimate solution to the debt ceiling crisis is.

First is the possibility that the split in America's two corporate parties is so profound that neither is willing to blink prior to the default date. They may both be so certain that the other party will be blamed for the fiasco - and so confident that the default will just be a minor bump - that they take the chance. So, let's take a look at what a default will mean.

At the most obvious level, no one will want to buy American bonds. Or, rather, they will want to be paid a premium interest rate before they will buy bonds to make up for the obviously heightened risk that the US won't make a payment. But, as economist Paul Krugman points out, this is already taking place in the context of what's called a liquidity trap. Basically, even with interest rates that approach zero, people would still rather not borrow or spend money, which they feel has more value and stability than debt. In other words liquidity is trapped because people hang on to it. If people are already not willing to borrow money when it is practically free, they are certainly not going to do so if interest rates rise significantly to make up for instability. And that's the trillion dollar question - would an increase in interest rates on short term government debt feed through to private interest rates. Again, according to Krugman:

What gets tricky here is the question of whether private borrowing costs rise in tandem. For corporate bonds, maybe not. But the GSEs (public enterprises - like the recently nationalized Fannie Mae and Freddie Mac - sw) pay rates that are tied to the cost of government borrowing, and they are the main sources of housing finance, so mortgage rates would probably rise.

The upshot of it all is that an increase in interest rates at present will definitely choke off the borrowing necessary to give the US economy any lift at all. It will mean an increase in foreclosures, already at record highs, and bankruptcies as debt servicing costs rise.

And that is only the most obvious effect. What is the great unknown is what the effect will be upon global stocks and the world financial system. After all, the US dollar is widely held as the international currency reserve and trillions of dollars in US debt are held by banks, countries and corporations around the world. The dollar will likely drop as Treasury Bills can only be sold at high interest rates and there is a "flight to stability" - we already have seen this with the appreciation in the value of the Canadian dollar or, rather, the depreciation of the US dollar. Will the global financial system lock up, as it did in 2008, as no bank can trust any nation, bank or corporation not to be over-exposed to devalued US debt, which must be written off against assets?

Of course, there will be a very immediate and obvious effect for a large section of the US population if a default happens - their cheques won't come. Social Security cheques won't get mailed, nor Medicare or other programs. People who do business with the federal government won't get paid and so, likely, their employees won't get paid either. With government spending there is something called a "multiplier effect" - basically, every one dollar that the government spends on things like infrastructure or services, is multiplied by the impact it has on the broader economy; the dollar pays a wage that is spent on consumer goods that helps to hire more workers, etc. Default will be like the multiplier effect running in reverse.


But even if Tweedle Dee and Tweedle Dum do manage to agree a compromise, which still seems most likely, there will be seriously negative economic effects. We saw with the Greek economy last year that when they implemented austerity measures as a condition for the first bailout, the result was to send the country into a recession that led to higher unemployment and lower tax revenues - which led to the need for a second tranche of bailout money this year (leading to strikes, riots, etc). That's because, according even to the IMF, every one percent cut in the deficit leads to a half a percentage decline in growth rates over two years. At present the US deficit - the annual revenue shortfall - is running at about $1.2 trillion with an accumulated debt of over $14 trillion. Both the Democrats and Republicans are agreed on plans to cut government spending by close to $3 trillion over ten years. It's not at all clear how they come to that number and for certain it is being boosted for public effect but using simplistic math it works out to something like $300 billion per year. That's 30 percent of the budget deficit, which can't be right or it's completely insane. But, for certain, what both Republicans and Democrats are talking about is austerity and austerity in the midst of an already weak economy will push its head back under water in what Krugman has called "the great mistake of 1937" when President Roosevelt and Congress decided to rein in spending, sending the US into a deep spiral that only ended with the massive arms build-up - and thus public spending - of the Second World War.

It's all so unnecessary. First off, the public debt is nothing compare to the private sector debt in the US economy. The US government - other than by idiocy - is nowhere near foreclosure, bankruptcy or risk-generated high interest rates. It is probably the most solvent part of the US economic system. Secondly, much more, if not all of they money could be generated by restoring tax rates on the wealthiest Americans that have been cut in the last thirty years. According to Tea Partiers - and agreed in practice by Obama and the Democrats. The "alternative plan" by Harry Reid, Democratic Senate Majority Leader, contains no tax increases on the wealthy. His plan is backed by Obama. But here's the thing - tax cuts have less negative effect on the economy than do cuts to "entitlements" and public services. The reason is simple: the rich have a surplus of income, which they put in the bank. Workers have little more than enough to get by and so spend their money buying goods and services rather than saving it. The utter failure of tax cuts, which were the mantra of the Bush years, ought to be obvious from the fact that the US economy is in the tank and debt levels have never been higher. Well, debt levels have never been higher for some. As Joseph Stiglitz, a Nobel winning economist wrote in an article in Vanity Fair in May:

The upper 1 percent of Americans are now taking in nearly a quarter of the nation’s income every year. In terms of wealth rather than income, the top 1 percent control 40 percent. Their lot in life has improved considerably. Twenty-five years ago, the corresponding figures were 12 percent and 33 percent. One response might be to celebrate the ingenuity and drive that brought good fortune to these people, and to contend that a rising tide lifts all boats. That response would be misguided. While the top 1 percent have seen their incomes rise 18 percent over the past decade, those in the middle have actually seen their incomes fall. For men with only high-school degrees, the decline has been precipitous—12 percent in the last quarter-century alone. All the growth in recent decades—and more—has gone to those at the top....

That is the real reason why the Democrats and Republicans can contemplate the pain of the cutbacks versus either stimulus spending to help the economy or tax increases on the top one percent to reduce the deficit. Because they are closer to the top one percent than they are to the bottom 99. As Stiglitz goes on to say:

Virtually all U.S. senators, and most of the representatives in the House, are members of the top 1 percent when they arrive, are kept in office by money from the top 1 percent, and know that if they serve the top 1 percent well they will be rewarded by the top 1 percent when they leave office. By and large, the key executive-branch policymakers on trade and economic policy also come from the top 1 percent.

So, don't lose any sleep for the politicians who are bickering over which of them gets to drive the high speed train into the depths of hell. They aren't losing sleep. After all, it's us who will be on the train. They'll be watching it on Fox News and CNN and congratulating themselves on what a great job they've done.

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