Saturday January 12, 2013

Growth dims after the ‘cliff’


IT was a close shave. It even passed the 31st midnight deadline.

But in the end (as always with politicians), the United States avoided falling off the cliff in the new year with again Band-Aid half measures. The International Monetary Fund (IMF) is right: US actions to avoid the cliff did not go far enough to address the nation's long-term fiscal deficit and debt problems: “More remains to be done to put US public finances back on a sustainable path without harming the still fragile recovery.”

For Moody's, the United States needs to do much more to lift its Aaa debt rating from the current negative outlook.

Of course, it did bring in the first major tax increase on high earners in 20 years. But this is not enough to provide a basis for meaningful improvement in its debt ratios over the medium term. Most economists concede that the deal will negatively impact growth and blunt efforts to create more jobs, but will likely avoid the most feared, a double-dip recession. Much uncertainty remains.

Cliff' deal

Major elements of the compromise deal included:

● Raise tax rates to 39.6% on income over US$400,000. For earners below this threshold, the lower 2012 tax rates will now become permanent

● Limit value of personal exemptions/deductions

● Raise capital gains/dividends tax to 20% (from 15%)

● Raise estate-tax to 40% (from 35%) for assets more than US$5mil

● Delay of US$110bil in spending cuts for two months, including on defence

● Lapse in payroll tax cuts (6.2%)

● Extend unemployment benefits for another year

● Extend tax breaks for research and development, interest on student loans

Also included were no hike in milk prices and extending certain farm subsidies. Left out, however, were disaster-relief funds.

Overall, the upshot is a minus. US growth was already expected to be rather flat before the cliff will rise at about the 2012 rate in 2013, i.e. 1.5%-2%. This deal could shave off 1.4 percentage points in potential GDP, and hold back job creation by up to 700,000. Much of the restraint reflected the rise in payroll taxes (pulling out US$113bil in otherwise spending on consumption); in delayed spending cuts, and in higher income taxes. There is more to come.

US debt ceiling

Potentially the most ominous hurdle to come is the need to raise the debt ceiling of US$16.394 trillion. As I see it, by the end of February, US Treasury is likely to be unable to pay all its bills unless Congress authorises to boost the borrowing limit.

I also understand that on March 1, the across-the-board spending cuts of the fiscal cliff (now deferred) are scheduled (i.e. sequestered) to begin slicing into military and social programmes.

By March 27, a government shutdown looms (as it did in August 2011 to the point where the United States was on the brink of default before hammering out a last minute deal), unless Congress approves funding government operations for the rest of the fiscal year ending Sept 2013.

In the wake of the recriminations and unpleasantness of the recent fiscal cliff fiasco, another nail-biting last minute showdown looks inevitable.

At risk is whether the United States has the ability to pay its bills. Already, US President has shown a new assertiveness that he will not negotiate over the debt ceiling this time around arguing Congress has the obligation to pay the bills for previously approved spending.

A lot is at stake. Bear in mind S&P has placed a “negative” outlook on US AA-plus rating while Fitch Ratings, like Moody's, maintains an AAA for the United States with a “negative” outlook.

Budget deficit

It is important to note that the deal does little to the US fiscal deficit. The non-partisan CBO (Congressional Budget Office) had estimated in early 2011 that in order to hold its share of debt to GDP, the United States needs US$4 trillion in spending cuts and new tax revenues over the next 10 years.

In August 2011, ceilings on spending were set on about one-third of federal spending in order to save US$1 trillion. That's US$3 trillion more to go. This latest deal is estimated to bring in new revenues of US$600mil-US$650mil.

There are no spending cuts as yet that's in the works. So, a big hole still remains. The federal debt stands today at 73% of GDP. If nothing happens, this ratio will rise by year end to 79% that's double what it was in 2000. The United States has to face the reality of higher taxes and lower social benefits down the road.

Ideological divide

As I understand it, for Republicans the compromise cliff deal reflected a violation of the anti-tax orthodoxy that has defined the party. Its Senate leader has since laid out the position: “The tax issue is finished, over, completed ... Now the task is to tackle ... our spending addiction.”

Republicans appear to want big spending cuts, including on Medicare and social security pensions as a condition for raising the debt ceiling. For most Democrats, the focus must include some increases in tax revenue from tax reform (i.e. eliminating deductions and exemptions). They want a balanced approach to non-tax revenue and spending reductions.

The trouble is there is a left and a right, but without a magnet to pull them together. At this time, lurking in the background, I am afraid, is the deeper reality don't seem to be anything there even approaching a consensus.

In the absence of an evolving new centre, there is a need for a fresh mind-set to:

● Fix (reform) the tax system and

● Change entitlement programmes. “Trust across the aisle” is really crucial for this to happen.

US economy

Sure, the deal has avoided its worse-case scenario it could have precipitated a recession. But consumers now have less to spend (because of higher income and payroll taxes) in the face of the welcome extension of unemployment benefits, while businesses are accorded a raft of tax breaks to encourage them to invest.

The deal's net effects result in a tap on the brakes, with the economy still growing too slowly to bring down unemployment quickly. Mohamed EL-Erian of PIMCO (world's largest bond dealer) sums it up best: “The deal avoids the more extreme risks of the fiscal cliff, but it doesn't enhance in any durable manner the medium-term economic outlook, nor provide a foundation for better economic governance by Congress.”

The US economy has been growing since mid-2009, in contrast to the dismal ways of Europe, the United Kingdom or Japan. GDP per head has not returned to the pre-recession level (and won't do so until 2014). Unemployment, at 7.8%, won't fall below 6% before 2016. The prognosis is stable but quite uncertain.

The benchmark used to discern the pace at which the economy will grow without inflation is the potential GDP. As a guide, unemployment falls percentage point for every one percentage point rise in GDP above the long-term trend (2%-2.5% per annum).

Today, actual GDP growth lags behind potential. Fed chief Bernanke predicted that “effects of the crisis ... should fade as the economy heals.” But it also faces headwinds such as rising income inequality and eroding education competencies. Plenty of uncertainty still remains.

Make no mistake. Washington is dysfunctional. Recent experience offers little prospect that US politics can accomplish anything significant in the first quarter of 2013. The upshot is painfully slow growth this year as the economy struggles to gain momentum.

Corporates are holding back, fearing political fights will slacken recovery. Following an earlier slide in business confidence, consumer sentiment plummeted in December. Can expect investors, businesses and consumers to remain on edge as debt ceiling battle begins. Uncertainties abound affecting markets and the economy. Make everyone edgy and cautious about spending.

Growth update

My last column for 2012: “Bleak 2013 Outlook As Asia Remains Resilient” was written before the “Cliff” deal was struck. Since then, economies of the United States China and emerging markets have decoupled deeper from Europe where it wallows at various stages of recession and fiscal disarray.

Survey data published in early 2013 point starkly to this divide. Markit has the US and China coming in above the 50 index level (above 50 indicating expansion), with US manufacturing activity in December growing at its fastest rate in seven months; growth also picked up in China and Brazil.

But factory activity slowed down in eurozone in December as new orders tumbled. It remained entrenched in a steep downturn. German activity shrank for the 10th straight month, while French data fell in all but one of past 17 months; the slump in Spain deepened.

Eurozone is in a double-dip recession since 2009 and its GDP contracted again in the fourth quarter of 2012. Manufacturers look to be in for a tough 2013. Eurozone unemployment hit 11.8% in November 2012, with the number nudging close to 19 million the 19th rise in a row; the rate for young unemployed (age 24 and below) hit 24.4%, the highest since records began in 1995.

Spain recorded the highest unemployment (26.6%), worse than Greece. But for under 25s, both nations hit about 57%. In the US, the budget and debt ceiling wrangling still casts a long shadow but so far, has not dispelled the modest recovery; the US dollar has even began to strengthen vis-vis the euro and yen.

Asia and the BRICS (Brazil, Russia, India, China and South Africa), especially north-east Asia, offer their own challenges that could affect global stability. Only China has the clout to make a difference globally on its own. It is now beginning to emerge stronger.

The others face a variety of challenges, ranging from inflation to inadequate FDI inflows to labour unrest. Given strong regional rivalries and a lack of trust, problems are bound to fester, leading to complications down the road.

Overall, ongoing politics, eurozone instability, fragile economies and climate change (and rising green house emissions) present a curious mix of risks and concerns. This week, extreme weather showed its ugly head as Australia grappled with destructive wild fires, and temperatures in China plunged to a 28-year low.

The rising risk has to be mitigated. But underlying it all is a growing fear that politicians will continue to fail to address fundamental problems. As a result, businesses and consumers have since become more pessimistic about the political-economic outlook.

It just reflects the loss of confidence in leadership, especially over public governance. It is not surprising that for businesses and investors, severe wealth gaps, unsustainable public finances and dangers posed by severe weather present the biggest threats confronting the world today.

What, then, are we to do?

The advanced West, including the US, has been on an unsustainable fiscal path for years. Economists at the BIS (Bank of International Settlements, the world's central banks' bank) had predicted that unless radical reforms are adopted, the public debt of the US, France and Greece will reach over 400% of GDP by 2040, with Germany's rising above 300%.

Similarly, the ratio for Japan will be in the 600% range. Of course, this is merely extrapolatory. Creditors would have stopped lending long before these levels are reached. The message is clear: the West is effectively bankrupt. The depth of the problem goes beyond Bush tax cuts, or Obama's stimulus or European wasteful excesses or Greek tax avoidance.

Indeed, it can be traced back to the Great Depression and the rise of Keynesian macroeconomics which over the years, encouraged governments to spend and borrow beyond smoothing business cycles; and offered politicians a convenient way to meet electoral promises without raising taxes.

The reality is that they did not get to where they are now by accident. It's deep rooted and goes beyond technicalities. In the final analysis, policymakers and politicians need to address the “social contract” in the context of the welfare state, and the “philosophy” underpinning the politics and political institutional infrastructure.

Basically, they have to ascertain what government should provide and how it can be restrained from overreaching. I envy the Scandinavians as they appear to have come to terms with this fundamental issue and are happy to pay for it.

Former banker Dr Lin is a Harvard educated economist and a British chartered scientist who speaks, writes and consults on economic and financial issues.

Feedback is most welcome; email:

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