A “great haircut” for U.S. growth

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A “great haircut” to kick-start U.S. growth

By Jennifer Ablan and Matthew Goldstein NEW YORK

(Reuters) – More than three years after the financial crisis struck, the U.S. economy remains stuck in a consumer debt trap.

It’s a situation that could take years to correct itself. That’s why some economists are calling for a radical step: massive debt relief. Federal policy makers, they suggest, should broker what amounts to an out-of-court settlement between institutional bond investors, banks and consumer advocates – essentially, a “great haircut” to jumpstart the economy.

What some are envisioning is a negotiated process in which cash-strapped homeowners get real mortgage relief, even if it means forcing banks to incur severe write-downs and bond investors to absorb haircuts, or losses, in some of the securities sold by those institutions.

“We’ve put this off for too long,” said L. Randall Wray, a professor of economics at the University of Missouri-Kansas City. “We need debt relief and jobs and until we get these two things, I think recovery is impossible.”

The bailout of the nation’s banks, a nearly trillion dollar stimulus package and an array of programs by the Federal Reserve to keep interest rates near zero may have stopped the economy from falling into the abyss. But none of those measures have fixed the underlying problem of too much U.S. consumer debt.

At the start of the crisis, household debt as a percentage of gross domestic product was 100 percent. Today it’s down to 90 percent of GDP. But by historical standards that is high. U.S. households are still more indebted than their counterparts in Austria, Germany, Spain, France and even Greece – which is on the verge of defaulting on its government debt.

Tens of millions of U.S. citizens remain burdened with mortgages they can no longer afford, in addition to soaring credit card bills and sky high student loans. Trillions of dollars in outstanding consumer debt is stifling demand for goods and services and that’s one reason economists say cash-rich U.S. companies are reluctant to hire and unemployment remains stubbornly high.

Take Donald Bonner, for example, a 61-year-old from Bayonne, New Jersey, who lost his job working on a dock in June. Back in March, he attended a “loan modification” fair held by JPMorgan Chase in New York. He has lived in his home since 1970, but was on the verge of losing his job. After falling behind on his $2,800-a-month mortgage, he sought to reduce his monthly payment. Bonner says the bank denied the request on the grounds that he is ineligible because his income is higher than the minimum threshold set by the Federal government for loan modifications.

“They keep asking me for additional documentation,” Bonner said on Friday. “It seems to me there is never enough documentation and it has to be renewed every month. It does make you wonder with all this bailout money these banks have received, they don’t want to lend the money.”

DEBT JUBILEE

The idea of substantial debt restructurings and a haircut for bondholders has been raised by financial pundits, including Barry Ritholtz and Chris Whalen, two popular analysts and bloggers.

Renowned economist Stephen Roach, currently non-executive chairman of Morgan Stanley Asia, has gone a step further, calling for Wall Street to get behind what others have called a “Debt Jubilee” to forgive excess mortgage and credit card debt for some borrowers. The notion of a Debt Jubilee dates back to biblical Israel where debts were forgiven every 50 years or so. In an August appearance on CNBC, Roach said debt forgiveness would help consumers get through “the pain of deleveraging sooner rather than later.” (here)

But it’s not just the liberal economists and doom-and-gloom financial analysts calling for a great haircut. Even some institutional investors, who might suffer some of the impact of debt reductions on their portfolios, are seeing a need for a creative solution to the mess.

“If there is something constructive that can be done it should be,” said Ash Williams, executive director of the Florida State Board of Administration, which oversees $145 billion in public investments and pension money. “You don’t want to reward bad behavior and you don’t want to reward people who were irresponsible. But if there is a way to do well by doing good, then let’s take a look at it.”

To be sure, consumer debt levels have been coming down since the crisis began. The Federal Reserve Bank of New York reported in August that outstanding consumer debt has fallen from a peak of $12.5 trillion in third quarter of 2008 to $11.4 trillion. (NY Fed report: tinyurl.com/3uuvk8d) That’s a sign that consumers are getting less indebted.

But U.S. households are still carrying a staggering burden of debt.

As of June 30, roughly 1.6 million homeowners in the U.S. were either delinquent on mortgages or in some stage of the foreclosure process, according to CoreLogic. And the real estate data and analytics company reports that 10.9 million, or 22.5 percent, of U.S. homeowners are underwater on their mortgage — meaning the value of their homes has fallen so much it is now below the value of their original loan.

CoreLogic said the figure, which peaked at 11.3 million in the fourth quarter of 2009, has declined slightly not because home prices are appreciating but because a growing number of mortgages are entering foreclosure.

The nation’s banks, meanwhile, still have more than $700 billion in home equity loans and other so-called second lien debt outstanding on those U.S. homes, according to SNL Financial.

Debts owed by American consumers account for almost half of the nearly $9 trillion in worldwide bonds backed by pools of mortgages, car loans, credit card debt and student loans, which were sold to hedge funds, insurers and pension funds and endowments.

And that doesn’t include the $4.1 trillion in mortgage debt sold by government-sponsored finance firms Fannie Mae and Freddie Mac.

Kenneth Rogoff, professor of economics and public policy at Harvard University and former chief economist at the International Monetary Fund, has said the ongoing crisis should be called the “Second Great Contraction” because U.S. households remain highly leveraged. He says the high level of consumer debt is what distinguishes this from other recessionary periods.

COMPETING INTERESTS

For those in favour of a radical solution, there are a lot of headwinds.

Any debt reduction initiative must confront the issue of “moral hazard” – the appearance of giving a gift to an unworthy borrower who simply made unwise spending choices.

Institutional investors who own securities backed by pools of mortgages are reluctant to see struggling homeowners get their mortgages reduced because that means those securities are suddenly worth less. Any write-downs that banks are forced to take could imperil their capital levels.

Banks and bondholders, meanwhile, have competing interests. This is because mortgage write-downs depress the value of the securities in which mortgages are pooled and sold to investors. Big institutional investors like BlackRock have long argued that any meaningful principal reduction on a mortgage must also include a willingness by banks to take their own write-downs on any home equity loans, or second liens, taken out by the borrower on the property.

The banks continue to hold those second liens on their balance sheets and so far have been reluctant to mark down the value of those loans, even though the borrower often has fallen behind on their primary mortgage payments.

In other words, bondholders are taking the position if they must suffer losses, so must the banks.

“Institutional investors, pension funds and hedge funds all have fiduciary obligations and they can’t necessarily agree to haircuts solely because it may be good social policy,” Sylvie Durham, an attorney with Greenberg Traurig in New York, who practices in the structured finance and derivatives area.

Tad Rivelle, chief investment officer of fixed-income securities at TCW, which manages about $120 billion of which $65 billion is in U.S. fixed income, doesn’t support a big haircut. But he says he can see why some economists and consumer advocates would favor debt reductions and debt workouts as way of dealing with the financial crisis and freeing up more money for spending.

Barry Ritholtz, director of equity research at Fusion IQ and a popular financial blogger, said the standoff between the banks and bondholders is untenable and doing a good deal of harm. An early critic of the bank bailouts, Ritholtz says bankers and bondholders are all in denial and both need to get far more pragmatic.

“They’d be bankrupt if not for the bailouts,” says Ritholtz of the banks’ position. “For their part, bondholders need to understand that we’re not earning our way out of this mess and should eat losses now before they get nothing.”

TIME FOR A MEDIATOR?

Given the standoff, there’s a sense nothing will happen unless federal policymakers make the first move. The Fed reports that 71 percent of household debt in the U.S. is mortgage-related.

But so far Washington policymakers seem more content to rely on voluntary measures. The two main programs set up by the Obama administration to reduce home mortgage debt – the Home Affordable Refinance Program and the Home Affordable Modification Program – have had limited success.

To date, the U.S. Treasury Department reports that those voluntary programs have resulted in 790,000 mortgage modifications, saving those borrowers an average of $525 a month in payments. Many of those modifications, however, were for borrowers paying high interest rates, not ones underwater on their mortgages.

In fact, Bank of America, one of the nation’s largest mortgage lenders, said it has offered just 40,000 principal reductions to its borrowers.

U.S. administration sources told Reuters that they support the concept of carefully targeted principal reductions for underwater borrowers. But these sources, who did not want to be identified, say the administration cannot mandate banks and bondholders to accept any principal reductions absent Congress authorizing the procedure.

The sources point out that federal authorities don’t have a “magic wand” – even at Fannie Mae and Freddie Mac, the government-backed home-loan titans.

These sources explain that even though Fannie and Freddie are effectively owned by the federal government, they are controlled by an independent regulator, the Federal Housing Finance Agency. And it’s up to the FHFA, and not the administration, to approve any principal reductions on home loans involving Fannie and Freddie.

An FHFA spokeswoman declined to comment. The agency has repeatedly taken the position that its first job is protect taxpayers’ return on investment in Fannie and Freddie rather than reducing mortgages for underwater borrowers.

CLOCK TICKING

The fear of some economists is that the economy may be going into a double dip recession. That means precious time is being lost if a negotiated approach to debt reduction isn’t taken now.

But the banks also have their own big debt burdens to deal with. Next year alone, U.S. banks and financial institutions must find a way to either pay off or refinance $307.8 billion in maturing debt, compared to the $182 billion that is coming due this year, according to Standard & Poor’s.

This maturing debt for U.S. banks comes at a time when they must start raising capital to deal with new international banking standards and are facing the possibility of a new recession that will crimp earnings. (Bank of America story: link.reuters.com/sys63s)

Beyond bank debt, hundreds of billions of dollars in junk bonds sold to finance leveraged buyouts also are maturing soon. S&P says “the biggest risk” comes in 2013 and 2014, when $502 billion in speculative-grade debt comes due.

Still, there are still plenty of economists who say the concern about consumer debt is overdone and that doing anything radical now would only make things worse. One of those is Mark Zandi, chief economist of Moody’s Analytics, who says a forced write-down or haircut of debt “would only result in a much higher cost of capital going forward and result in much less credit to more risky investments.”

He said significant progress has been made in reducing private sector debt, and draconian debt forgiveness measures would be a mistake. “Early in the financial crisis I was sympathetic to passing legislation to allow for first mortgage write-downs in a Chapter 7 bankruptcy, but the time for this idea has passed,” says Zandi.

Still, the notion of a debt write-down and bondholder haircuts will probably be around as long as the unemployment rate stays high and the housing market remains depressed.

Indeed, it has been two years since the notion of a “Debt Jubilee” made it into the popular culture when Trey Parker and Matt Stone used it for an episode of the politically incorrect cartoon “South Park.” In the episode aired in March 2009, (here), one of the characters used an unlimited credit card to pay off all the debts of the residents of South Park to spur the economy.

At the time, the idea seemed like just a funny satire on the nation’s economic mess. But now it seems like no joke at all.

(Reporting by Jennifer Ablan and Matthew Goldstein; Additional reporting by David Henry and Joseph Rauch; Editing by Michael Williams and Claudia Parsons)

Europe puts its head in sand over growth crisis

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By Alan Wheatley, Global Economics CorrespondentLONDON | Mon Sep 5, 2011

(Reuters) – Japanization is shorthand for slouching toward that country’s noxious mix of low growth and high debt. Euro zone governments will find it tough to keep the ugly new word out of their lexicon.

Concern is mounting over a deterioration in Europe’s long-term growth prospects that, unaddressed, will make it even harder to tackle the banking and debt problems underlying the current life-or-death struggle over the euro.

The financial crisis that has been rocking the global economy since 2008 has permanently reduced trend growth across the industrial world. The Organization for Economic Cooperation and Development in Paris reckons the potential output of its 34 member countries has dropped by about 2.5 percent.

“A lot of countries are going to take a permanent hit to their trend rate of growth. This is not an ordinary recession and so we’re not going to see countries bouncing back to pre-crisis rates of growth,” said Philip Whyte, a senior research fellow at the Center for European Reform, a London think-tank.

As firms have gone bust, capacity has been lost for good. With demand subdued, profitable companies are not replacing old plants.

And as high unemployment persists, skills atrophy. This weakens productivity and shuts people out of the job market for longer and longer periods — a danger stressed by Federal Reserve Chairman Ben Bernanke at the U.S. central bank’s Jackson Hole symposium last month.

Apart from sapping animal spirits and forcing governments to raise taxes or cut spending, diminished growth closes off one route for lowering the high sovereign debt to gross domestic product ratios that have locked Greece, Ireland and Portugal out of the bond markets and are unnerving investors in Italian and Spanish debt.

Against this background, and with the scope for fiscal and monetary stimulus all but exhausted, politicians might be expected to grasp the nettle and push through reforms to improve the supply side of the economy — policies such as making it easier to hire and fire, promoting greater competition and investing more in training.

Far from it. Pier Carlo Padoan, the OECD’s chief economist, says he is less optimistic about the prospects for deep-seated change than he was at the start of the year.

“I see that measures are being announced. I would like to see them being implemented,” Padoan said.

With policy ammunition running desperately short, he said it was time for governments to overcome their squeamishness about confronting vested interests opposed to change. “This is a luxury that many countries cannot afford any more. The situation does not allow it.”

SOUTHERN DISCOMFORT

The vicious circle of rising debt and falling growth is made worse by the fact that those countries drowning in debt on the periphery of the euro zone are also the ones that have dragged their feet on freeing up their product and labor markets or modernizing their education systems.

“They’re going through some truly horrible times. I’m very worried about the whole southern European fringe, not just on an 18-month to 2-year view but looking out a decade or longer,” said Whyte with the Center for European Reform.

Germany, by contrast, derided a decade ago as the sick man of Europe, is being held up as a model, at least when it comes to jobs.

“The remarkable resilience of the German labor market in the last few years, where wage moderation and flexible time accounting shielded the economy from excessive job destruction, illustrates admirably the promise of well-structured reforms,” Jean-Claude Trichet, president of the European Central Bank, said approvingly in Jackson Hole.

How much are countries missing out by not pressing the reform button?

Padoan says Europe’s trend growth has fallen in recent years to an average of just 1.5 percent a year, but he says some members of the 17-nation euro zone could almost double that rate with a supply-side jolt.

Italy needs to liberalize its service sector, open up professions to new entrants and improve energy efficiency, Padoan said. Greece needs to do all that and overhaul its labor market and competition policy at the same time.

POOR ADVERT FOR FREE MARKETS

Germany, too, could grow faster still if it liberalized services, which would trigger increased investment.

These policy prescriptions are well worn. Leaders of the European Union enshrined them and a host of other reform goals in the 2000 Lisbon Agenda, which they promptly ignored. The pledges have since been repackaged as the Europe 2020 Strategy, but Whyte says the havoc wrought by the near-collapse of the international financial system will make politicians more wary than ever of the social disruption that reforms entail.

“The Great Financial Crisis hasn’t been a great advert for free-market capitalism,” said Whyte. His research outfit publishes a booklet this week exploring how Europe could take off by embracing innovation. But in this area, too, Whyte fears the political climate means policy is likely to be increasingly hijacked by incumbent firms hostile to competition from start-ups.

Europe is not doomed to go down Japan’s path of economic stagnation. Its potential growth rate is low but stronger than Japan’s — estimated by the Bank of Japan at just 0.5 percent a year because of a fast-shrinking working-age population.

But the specter of a renewed recession is a reminder for governments that, even if they can spirit away the euro zone’s currency and debt woes, they have still to find the elixir for growth.

“I’m not saying politicians will implement reform, but they should,” Padoan said. “Some politicians resist reform because they are captive to interest groups. Well, the price for those governments in terms of sustainable growth will be very high.”

(Reporting by Alan Wheatley; Editing by Ruth Pitchford)

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US Treasuries not safe, said don

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Don: US Treasuries not safe, emerging economies should find other ways to buffer themselves

Image via WikipediaJACKSON HOLE, Wyoming: Emerging economies should find other ways to buffer themselves from global crises than stockpiling US government debt, a prominent economist argued.

US Treasuries and the debt of other advanced nations might be liquid, but it was far from safe, Cornell University professor Eswar Prasad said in a paper presented to a group of central bankers gathered here.

Emerging countries seeking protection from global shocks by individually stocking up on US debt would be better off banding together to create a pool of funds that could be drawn on in a crisis, he argued. Doing so would give them a backstop should they need it, without saddling their national investment portfolios with debt that could turn sour.

Sharply rising levels of public borrowing and weak growth prospects in the United States mean that over time the dollar will continue to decline against the currencies of faster-growing emerging markets, eroding the value of emerging nations’ foreign investments, he said. And the risks are not only for the long-term. The United States’ near brush with default earlier this month, as lawmakers refused to raise the country’s borrowing ceiling until a deficit-cutting deal was reached, brought the potential pitfalls of holding US debt into sharp relief.

“As demonstrated by recent events in the eurozone, bond investors both domestic and foreign can quickly turn against a vulnerable country with high debt levels, leaving the country little breathing room on fiscal tightening and precipitating a crisis,” Prasad wrote. “The US is large, special and central to global finance, but the tolerance of bond investors may have its limits.”

The dollar has long been the world’s main reserve currency, and since the financial crisis emerging economies have built their reserves by buying Treasuries and the debt of a few other advanced economies, according to Prasad.

Any change could hurt the ability of the United States to borrow at low rates despite soaring debt levels.

That would turn the tables in a world where traditionally it was developed nations that pressured developing ones to bring their finances under control, he said.

“It is high time for advanced economies to take the tonic of macroeconomic and structural reforms that they have for so long dispensed to the emerging markets,” he said. Reuters

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China’s US$3.2 trillion headache

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ENTER THE DRAGON By YAO YANG

WHILE the downgrade of US government debt by Standard & Poor’s shocked global financial markets, China has more reason to worry than most: the bulk of its US$3.2 trillion in official foreign reserves more than 60% is denominated in dollars, including US$1.1 trillion in US Treasury bonds.

So long as the US government does not default, whatever losses China may experience from the downgrade will be small. To be sure, the dollar’s value will fall, imposing a balance sheet loss on the People’s Bank of China (PBC, the central bank). But a falling dollar would make it cheaper for Chinese consumers and companies to buy American goods.

If prices are stable in the United States, as is the case now, the gains from buying American goods should exactly offset the PBC’s balance sheet losses.

The downgrade could, moreover, force the US Treasury to raise the interest rate on new bonds, in which case China would stand to gain. But S&P’s downgrade was a poor decision, taken at the wrong time. If America’s debts had truly become less trustworthy, they would have been even more dubious before the agreement reached on Aug 2 by Congress and President Barack Obama to raise the government’s debt ceiling.

That agreement allowed the world to hope that the US economy would embark on a more predictable path to recovery. The downgrade has undermined that hope. Some people even predict a double-dip recession. If that happens, the chance of an actual US default would be much higher than it is today.

 Reason to worry: China’s US$3.2 trillion problem will become a 20-trillion-renminbi problem if China cannot reduce its current account surplus and fence off capital inflows. — AP

These new worries are raising alarm bells in China. Diversification away from dollar assets is the advice of the day. But this is no easy task, particularly in the short term. If the PBC started to buy non-dollar assets in large quantities, it would invariably need to convert some current dollar assets into another currency, which would inevitably drive up that currency’s value, thus increasing the PBC’s costs.

Another idea being discussed in Chinese policy circles is to allow the renminbi to appreciate against the dollar. Much of China’s official foreign reserves have accumulated because the PBC seeks to control the renminbi’s exchange rate, keeping its upward movement within a reasonable range and at a measured pace.

If it allowed the renminbi to appreciate faster, the PBC would not need to buy large quantities of foreign currencies.

International experience

But whether renminbi appreciation will work depends on reducing China’s net capital inflows and current account surplus. International experience suggests that, in the short run, more capital flows into a country when its currency appreciates, and most empirical studies have shown that gradual appreciation has only a limited effect on countries’ current account positions.

If appreciation does not reduce the current account surplus and capital inflows, then the renminbi’s exchange rate is bound to face further upward pressure. That is why some people are advocating that China undertake a one-shot, big-bang appreciation large enough to defuse expectations of further strengthening and deter inflows of speculative “hot” money. Such a revaluation would also discourage exports and encourage imports, thereby reducing China’s chronic trade surplus.

But such a move would be almost suicidal for China’s economy. Between 2001 and 2008, export growth accounted for more than 40% of China’s overall economic growth. That is, China’s annual gross domestic product (GDP) growth rate would drop by four percentage points if its exports did not grow at all. In addition, a study by the China Centre for Economic Research has found that a 20% appreciation against the dollar would entail a 3% drop in employment more than 20 million jobs.

There is no short-term cure for China’s US$3.2 trillion problem. The government must rely on longer-term measures to mitigate the problem, including internationalisation of the renminbi. Using the renminbi to settle China’s international trade accounts would help China escape America’s beggar-thy-neighbour policy of allowing the dollar’s value to fall dramatically against trade rivals.

But China’s US$3.2 trillion problem will become a 20-trillion-renminbi problem if China cannot reduce its current account surplus and fence off capital inflows. There is no escape from the need for domestic structural adjustment.

To achieve this, China must increase domestic consumption’s share of GDP. This has already been written into the government’s 12th Five-Year Plan. Unfortunately, given high inflation, structural adjustment has been postponed, with efforts to control credit expansion becoming the government’s first priority. This enforced investment slowdown is itself increasing China’s net savings, i.e., the current account surplus, while constraining the expansion of domestic consumption.

Real appreciation of the renminbi is inevitable so long as Chinese living standards are catching up with US levels. Indeed, the Chinese government cannot hold down inflation while maintaining a stable value for the renminbi. The PBC should target the renminbi’s rate of real appreciation, rather than the inflation rate under a stable renminbi. And then the government needs to focus more attention on structural adjustment the only effective cure for China’s US$3.2 trillion headache. – Project Syndicate

● Yao Yang is Director of the China Center for Economic Research at Peking University.

US no longer ‘AAA’, Eurozone the next?

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US no longer ‘AAA’

WHAT ARE WE TO DO By TAN SRI LIN SEE-YAN

STANDARD & Poor’s (S&P’s) had on Aug 5 cut the US long-term credit rating by a notch to AA-plus (from AAA). This unprecedented move reflected concerns about the US’s budget deficits and rising debt burden. It called the outlook “negative,” indicating that another downgrade is possible in the next 12-18 months.

According to S&P’s, the Aug 2 debt deal which cut spending by US$2.1 trillion, didn’t go far enough: “It’s going to take a deal about twice the size to stabilise the debt to GDP ratio.” It also stressed what it saw as the inability of the US political establishment to commit to an adequate and credible debt reduction plan: “The effectiveness, stability & predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.” Moody’s Investors Service and Fitch Ratings haven’t followed S&P’s move causing a split rating. They had earlier (on Aug 2) affirmed their AAA credit ratings for the US, while warning that downgrades were possible, grading the outlook as negative. At the same time, China’s only rating agency (Dagong Global Credit Rating) downgraded the US from A-plus to A saying the deal won’t solve underlying US debt problems.

US downgrade

What does a rating downgrade mean? For the US, it will affect its borrowing costs eventually and immediately, investor opinion of US assets. According to Sifma (a US securities industry trade group), the downgrade could add up to 0.7 of 1 percentage point to US Treasury yields, thereby increasing funding costs for US public debt by some US$100bil. But the US dollar has a special position as the numeraire of global transactions; it is also a reserve currency, and often regarded as a safe haven in times of uncertainty. Ironically, in the recent sell-off in equities world-wide following the S&P’s downgrade, US government bonds was a big beneficiary. Its benchmark 10-year bond yields fell 21 basis points on Monday to 2.35%, the biggest one day drop since January 2009; by Wednesday, it was 2.14%, the lowest yield on record. Two year US Treasuries yield touched a record low of 0.23% and then, fell further to 0.184% on Wednesday. In the panic, Treasuries appear to be still the way to go.

With the downgrade, US no longer warrant the top-tier rating it enjoyed since 1941 (Moody has had a AAA on the US since 1917). At AA+, the US is still considered to have a “strong” ability to service its debt. Only Canada, Germany, France & UK still carry triple-A at S&P’s. The downgrade didn’t affect US short-term rating which remains at A-1+, the highest at S&P’s. In a follow through, S&P’s downgraded numerous government related enterprises (notably Fannie Mae and Freddie Mac which together hold more than one-half of US mortgages), 73 investment funds (fixed income funds, hedge funds, etc) and 10 insurance companies for their large holdings of Treasuries. But banks were spared on the implicit “too big to fail” policy of the government. Nevertheless, the US bond market retains widespread appeal. At more than US$35 trillion at end-March, this market is broad, liquid and deep. The Treasuries market alone has US$9.3 trillion debt outstanding. But in the end, the market decides. Consider Japan S&P’s downgraded it in 2002. Today, Japan is still able to borrow freely & cheaply. As of Aug 9, interest rate on Japan’s 10-year bonds stood at just 1.045% and 30-years, at below 2%. In practice, for the US, a double A-plus still works like a de facto triple-A.

 Market rebound: Traders work on the floor of the New York Stock Exchange on Thursday — AP

Immediate global sell-off

When markets opened following the weekend downgrade, a global panic sell-off in equities took over. There was a lot of fear and uncertainty in the markets, reflecting a confluence of three main factors:

● uncertainty about the US economy faltering, raising the risk of a double-dip recession;

● worries that the downgrade could further undermine US consumer confidence & business spending adding another layer of anxiety on the global economic outlook; and

● fear the euro-zone debt crisis will spin out of control, spooking investors.

All this took its toll. Stock markets plunged around the world with funds flowing into havens, such as gold (up 60% since 2010, surpassing US$1,800 a troy ounce), Swiss francs (up 24% against euro and 32% on US dollar over the past year) and ironically, US Treasuries. In Asia, markets closed at their lowest levels in about a year. Key benchmarks in Hong Kong, Seoul, Mumbai and Sydney skidded for the fifth consecutive day. Shares in China, Taiwan and South Korea plunged sharply before recovering some ground. All closed nearly 4% lower on Monday. In Hong Kong, the Hang Seng Index had its worst day since the 2008 financial crisis, falling another 5.6% on Tuesday; it had fallen by 16.7% in the past six sessions, or more than 20% from its recent peak. South Korea’s Kospi was down 3.6% and Indonesia’s main stock exchange fell 3%. At its close, the KL Bursa lost another 1.7% on Aug 9 (-1.8% on Aug 8). Japan’s Nikkei fell 2.2% to its weakest level since the March earthquake. India’s Bombay stock index declined 1.6%, its fifth drop in a row.

The Dow Jones Industrial Average (DJIA) recovered 1.5% on Tuesday after a record 635 point fall (-5.5%) in sell-offs on Monday. The German DAX closed further down 5% and the Paris CAC 4.7% lower while the FTSE 100 in London fell another 3.4%. The Stoxx Europe 600 index ended 1.4% higher following a 4.1% slide on Monday, although underlying sentiment remained extremely fragile. The VIX which tracks stock market volatility, reached its highest since the initial Greek debt crisis in May 2010. It rose 20% to 38.5 on Monday afternoon and then to 40.5 on Tuesday, reflecting extreme fear and emotional trading. It measures the price investors pay for protective options on the S&P’s 500 index. After Monday’s sharp share-price drop and the previous week’s poor performance, China and Hong Kong aren’t the only markets at or near bear territory. Stocks in Germany & France are now down more than 20% (definition of a bear market), from highs reached in the previous year. India’s benchmark Bombay Sensex is down 20%, and Japan’s Nikkei is off 16.5%.

A day after US stocks received a boost from the Fed to keep interest rates low until 2013, markets in the US and Europe resumed their plunge on Wednesday. The fear: politicians across the Atlantic won’t be able to manage the significant headwinds buffeting the US & European economies. Woes were focused on France, where its bank stocks plunged amid worries it may lose its triple-A status. The Paris CAC-40 index fell 5.4%. In the US, the DJIA was down 4.62% (-520 points) wiping out Tuesday’s surge. The Fed had run out of bullets. Asian stocks advanced Wednesday with sentiment helped by a strong Wall Street rebound. However, gains in most markets lacked the passion observed on the way down. Hong Kong was up 2.3%, South Korea, 0.3% and Taiwan, 3.3%. All three were still down more than 10% so far in August. Japan was up 1.1%, Australia, 2.6% and China, 0.9%. But Stoxx Europe 600 was down 3.7%. Expectations are for the markets to remain choppy. On Thursday, most Asian markets were back in negative territory. But Europe closed stronger (up about 3%) and the DJIA surged by 4% (+423 points).

European contagion

Italy and Spain, the euro-zone’s third and fourth largest economies, have a combined GDP of nearly 2.7 trillion euros, about 30% of the eurozone total. For nearly two years, the European Union (EU) has been trying to stem the unfolding debt crisis. The July 21 Greek bailout bought some time not much to ward off further contagion. The European Central Bank’s (ECB) decision on Aug 7 to buy Italian and Spanish debt represents a watershed in EU’s continuing battle against turning ECB into the lender of last resort. The ECB has insisted the main responsibility to act lies with national governments. Given worries of a new bout of contagion sweeping European and global markets, ECB defended the new intervention as restoring the “normal functioning of markets through a better transmission of monetary policy.” ECB’s continued bond-buying brought benchmark Spanish borrowing costs for 10-year bonds down to 5.019% on Tuesday, close to their lows for the year. Italian 10-year bond yields also fell to a one month low of 5.143%. Both countries’ yields had approached 6.5% last week a level that eventually escalated to push Greece, Ireland & Portugal into bail-outs. Analysts estimate ECB could have bought up to 10 billion euros, a small fraction relative to the size of Spain & Italy’s debt markets. Italy’s debt alone is 1.8 trillion euros.

Market sentiment aside, the purchases did little to change the fundamental backdrop in Europe where economic growth has slowed even in the “core” nations of Germany & France. Signs of stress remain despite the positive market reactions to ECB’s decision. Deposits at ECB, for example, hit a 2011 high of 145 billion euros on Monday, reflecting banks’ reluctance to lend inter-bank preferring the safety of ECB. There is a limit to how deeply ECB can be drawn into the fiscal misadventures of its members. Concerns are mounting on the French economy because of its high debt levels (85% of GDP, already above the US & rising) and weak growth prospects. Germany, in much better shape, isn’t immune either. Already, the cost of insuring German bonds against default using credit-default swaps (CDSs) rose above 85 basis points, higher than insuring UK bonds for the first time on Tuesday, despite the London riots. There is growing concern the new austerity measures in Italy & Spain will slacken their struggling economies, plagued also by social unrest.

What’s wrong with the US economy?

The recession ended two years ago. The stumbling recovery may turn out to be the worst ever. Most indicators are not reassuring unemployment at 9.1% is still too high and jobs creation too slow; GDP growth is faltering, income growth continues lagging behind; household wealth is falling; banks are not lending enough; and consumer expectations have not been positive. In the last eight recoveries, lost jobs were regained within two years of recession’s end. This recovery is still seven million jobs below peak employment in 2008 and about two million fewer than if unemployment was held below 8%. The US economy will remain lacklustre for some years because of heavy household debt, a financial system deeply scared by mortgages, and a dysfunctional political establishment. Heavy household debt and a dismal job market have hurt consumers’ confidence, further dampening their willingness to spend. The only bright spot is exports, reflecting the weak US dollar and still booming emerging economies. Unexpectedly, the pace of growth in US services fell in July to its lowest level since February 2010. Taken alongside disappointing manufacturing data, the services sector showed-up an economy with weak hopes of a rebound in the second half of this year, after an anaemic first half. According to Harvard’s Martin Feldstein, “This economy is really balanced on the edge. There is now a 50% chance that we could slide into a new recession.” Even Prof Larry Summers now concedes: “The odds of the economy going back into recession are at least one in three.”

The US problem is more a job and growth deficit than an excessive budget deficit. The diagnosis of the run-up in debt out of control spending by the Federal government, is exaggerated. Indeed, the “cure” of severe spending cuts is likely to make recovery more difficult. The real problem lies in the fall-off in tax revenue. From 20% of GDP in 1998-2001, tax revenue has fallen steadily: averaging just 17% of GDP from 2002-08 and then, to below 15% in 2009-10. About 50% of the rise in deficit was due to the downturn because of “automatic stabilisers”, reflecting cyclical revenue falls and higher spending to assist the unemployed and other transfers to help the poor. They contribute to demand and assist to “stabilise” the economy.

The US rating downgrade is a warning bell. On present trend, its debt burden is unsustainable and the US political system seems unable to reverse it. To do so, it needs faster growth can’t cut its way to growth. What’s required is tax reform and a will to restore revenues back to the 20% of GDP trend; a prospect most Republicans have castigated. At issue is not the US government’s capacity to service its debt, John Kay of the Financial Times pointed out. It is the “willingness of the government to repay.” If sovereign borrowers meet their obligations, it is only because “they want to.”

● Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching & promoting the public interest. Feedback is most welcome; email: starbizweek@thestar.com.my.

Simple way to understand US Economic Situation

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US loses AAA credit rating, why? Dollar sluggish, Trade in RMB!

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US loses AAA credit rating from Standard & Poor’s

The White House maintained silence in the immediate aftermath of S&P downgrade. — Photo by AFP

NEW YORK: The United States lost its top-notch AAA credit rating from Standard & Poor’s on Friday in an unprecedented reversal of fortune for the world’s largest economy.

S&P cut the long-term US credit rating by one notch to AA-plus on concerns about the government’s budget deficits and rising debt burden. The move is likely to raise borrowing costs eventually for the American government, companies and consumers.

“The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilise the government’s medium-term debt dynamics,” S&P said in a statement.

The decision follows a fierce political battle in Congress over cutting spending and raising taxes to reduce the government’s debt burden and allow its statutory borrowing limit to be raised.

On August 2, President Barack Obama signed legislation designed to reduce the fiscal deficit by $2.1 trillion over 10 years. But that was well short of the $4 trillion in savings S&P had called for as a good “down payment” on fixing America’s finances.

The White House maintained silence in the immediate aftermath of S&P downgrade.

The political gridlock in Washington and the failure to seriously address US long-term fiscal problems came against the backdrop of slowing US economic growth and led to the worst week in the US stock market in two years.

The S&P 500 stock index fell 10.8 per cent in the past 10 trading days on concerns that the US economy may head into another recession and because the European debt crisis has been growing worse as it spreads to Italy.

US Treasury bonds, once undisputedly seen as the safest security in the world, are now rated lower than bonds issued by countries such as Britain, Germany, France or Canada.

‘Daunting implications’

As the focus for investors shifted from the debate in Washington to the outlook for the global economy, even with the prospect of a downgrade, 30-year long bonds had their best week since December 2008 during the depth of the financial crisis.

Yields on 10-year notes, a benchmark for borrowing rates throughout the economy fell as far as 2.34 per cent on Friday — their lowest since October 2010 — also very low by historical standards.

“To some extent, I would expect when Tokyo opens on Sunday, that we will see an initial knee-jerk sell-off (in Treasuries) followed by a rally,” said Ian Lyngen, senior government bond strategist at CRT Capital Group in Stamford, Connecticut.

The outlook on the new US credit rating is “negative,” S&P said in a statement, a sign that another downgrade is possible in the next 12 to 18 months.

“The long-term implications are daunting. Short-term, Treasuries remain a premier safe-haven refuge,” said Jack Ablin, chief investment officer at Harris Private Bank in Chicago.

Borrowing costs could rise

The impact of S&P’s move was tempered by a decision from Moody’s Investors Service earlier this week that confirmed, for now, the US Aaa rating. Fitch Ratings said it is still reviewing the rating and will issue its opinion by the end of the month.

“It’s not entirely unexpected. I believe it has already been partly priced into the dollar. We expect some further pressure on the US dollar, but a sharp sell-off is in our view unlikely,” said Vassili Serebriakov, currency strategist at Wells Fargo in New York.

“One of the reasons we don’t really think foreign investors will start selling US Treasuries aggressively is because there are still few alternatives to the US Treasury market in terms of depth and liquidity,” Serebriakov added.

S&P’s move is also likely to concern foreign creditors especially China, which holds more than $1 trillion of US debt. Beijing has repeatedly urged Washington to protect its US dollar investments by addressing its budget problem.

Obama administration officials grew increasingly frustrated with the rating agency through the debt limit debate and have accused S&P of changing the goal posts in its downgrade warnings, sources familiar with talks between the administration and the ratings firm have said.

The downgrade could add up to 0.7 of a percentage point to US Treasuries’ yields over time, increasing funding costs for public debt by some $100 billion, according to SIFMA, a US securities industry trade group.

S&P had placed the US credit rating on review for a possible downgrade on July 14 on concerns that Congress was not adequately addressing the government fiscal deficit of about $1.4 trillion this year, or about 9.0 per cent of gross domestic product, one of the highest since World War II.

The unprecedented downgrade of the nation’s AAA credit rating by a major ratings agency comes only 15 months before the next presidential election where the downgrade and the debt will be top issues for debate.

Bitter political battles remain over the ideologically fraught issues of spending cuts and tax reform.

The compromise reached by Republicans and Democrats this week calls for the creation of a bipartisan congressional committee to find $1.5 trillion of deficit cuts by late November, beyond the $917 billion already identified.

Why S&P downgrades US credit rating?

The credit rating agency Standard & Poor’s on Friday cut the United States’ credit rating to AA+ from AAA, citing three fundamental reasons for the downgrade, the first ever in US history.

Debt burden worry

According to S&P’s judgment, the debt situation of the United States doesn’t satisfy the requirement of an AAA rating.

S&P compared US debt with the other four countries with AAA ratings: Canada, France, Germany and Britain.

It estimated the five countries will have net general government debt to GDP ratios this year ranging from 34 percent of Canada to 80 percent of Britain, with the US debt burden at 74 percent.

S&P predicted the net public debt to GDP ratios will range between 30 percent of Canada and 83 percent of France, with the US debt burden at 79 percent.

Although the US ratio of net public debt to the GDP was not the highest among the five countries, the rating agency projected that the net public debt burden of the other four countries will begin to decline, either before or by 2015.

Fiscal plan “not enough”

On August 2, US President Barack Obama signed legislation designed to reduce the fiscal deficit by $2.1 trillion over 10 years.

However, according to S&P’s calculations, a good “down payment” on fixing the country’s finances would be at least $4 trillion.

“The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics,” S&P said.

The rating agency believed the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicated that further near-term progress containing the growth in public spending, especially on entitlement, or on reaching an agreement on raising revenues is less likely than previously assumed and will remain a contentious and fitful process.

Lose faith on policy makers

S&P questioned US policy makers’ eagerness to solve the debt problems by bipartisan efforts. Also, the rating agency blamed Democrats and Republicans for ignoring its earlier warnings.

On April 18, S&P assigned a negative outlook to US then-AAA rating, warning the debt ceiling should be raised to avoid a default. However, the action didn’t draw much attention from policy makers who had decisive power to take quick measures.

The US debt would reach its ceiling of 14.3 trillion on August 2. If the debt ceiling was not raised, the United States would face an unprecedented default.

Through long, testy negotiations between the two parties in Congress, the plan was finally passed just before the August 2 deadline. However, patience and trust in US policy makers diminished as time went by.

“The effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned,” S&P said.

Also, as the difficulties behind the debt problems still loom ahead, S&P worried that US policy makers could not react properly and effectively to the “government debt dynamics” any time soon, given their recent performance on dealing with the debt ceiling.

Related Reading

1. Chinese agency downgrades US credit rating
2. Chinese rating agency downgrades U.S. credit rating after debt limit increase
3. Chinese ratings agency Dagong puts U.S. on watch for downgrade

US loses AAA credit rating after S&P downgrade

One of the world’s leading credit rating agencies, Standard & Poor’s, has downgraded the United States’ top-notch AAA rating for the first time ever.

News of the downgrade ended a tumultuous week for US finances

S&P cut the long-term US rating by one notch to AA+ with a negative outlook, citing concerns about budget deficits.

The agency said the deficit reduction plan passed by the US Congress on Tuesday did not go far enough.

Correspondents say the downgrade could erode investors’ confidence in the world’s largest economy.

It is already struggling with huge debts, unemployment of 9.1% and fears of a possible double-dip recession.

The downgrade is a major embarrassment for the administration of President Barack Obama and could raise the cost of US government borrowing.

This in turn could trickle down to higher interest rates for local governments and individuals.

Analysis - Robert Peston Business editor, BBC News

 The US losing its AAA rating matters. It is a very loud statement that there has been an appreciable increase in the risk – which might still be tiny, but it exists – that the US might one day struggle to pay back all it owes. Another important certainty in the world of finance has gone.

Of course many will argue – and already have – that the record of ratings agencies such as Standard & Poor’s of getting these things right in recent years has been lamentably poor. Think of all the subprime CDO products rated AAA by S&P that turned out to be garbage.

But S&P, Moody’s and Fitch (and particularly the first two) still have a privileged official position in the world of finance: they determine what collateral can be taken by central banks from commercial banks, when those central banks lend to commercial banks.

However, some analysts said with debt woes across much of the developed world, US debt remained an attractive option for investors.

The other two major credit rating agencies, Moody’s and Fitch, said on Friday night they had no immediate plans to follow S&P in taking the US off their lists of risk-free borrowers.

‘Flawed judgement’

Officials in Washington told US media that the agency’s sums were deeply flawed.

Unnamed sources were quoted as saying that a treasury official had spotted a $2 trillion [£1.2 trillion] mistake in the agency’s analysis.

“A judgment flawed by a $2tn error speaks for itself,” a US treasury department spokesman said of the S&P analysis. He did not offer any immediate explanation.

John Chambers, chairman of S&P’s sovereign ratings committee, told CNN that the US could have averted a downgrade if it had resolved its congressional stalemate earlier.

“The first thing it could have done is raise the debt ceiling in a timely matter so the debate would have been avoided to begin with,” he said.

International reaction to the S&P move has been mixed.

China, the world’s largest holder of US debt, had “every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets,” said a commentary in the official Xinhua news agency.

“International supervision over the issue of US dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country,” the commentary said.

However, officials in Japan, South Korea and Australia have urged a calm response to the downgrade.

The S&P announcement comes after a week of turmoil on global stock markets, partly triggered by fears over the US economy’s recovery and the eurozone crisis.

With a bill to raise the US debt ceiling finally passed, the US has managed to avoid the catastrophic effects of a debt default. Now the focus has moved to the underlying economy and whether GDP is about to stall.

S&P had threatened the downgrade if the US could not agree to cut its federal debt by at least $4tn over the next decade.

Instead, the bill passed by Congress on Tuesday plans $2.1tn in savings over 10 years.

S&P said the Republicans and Democrats had only been able to agree “relatively modest savings”, which fell “well short” of what had been envisaged.

The agency also noted that the legislation delegates the lion’s share of savings to a bipartisan committee, which must report back to Congress in November on where the axe should fall.

The bill – which also raises the federal debt ceiling by up to $2.4tn, from $14.3tn, over a decade – was passed on Tuesday just hours before the expiry of a deadline to raise the US borrowing limit.

S&P ratings (selected)

• AAA: UK, France, Germany, Canada, Australia
• AA+: USA, Belgium, New Zealand
• AA-: Japan, China

Source: S&P

S&P said in its report issued late on Friday: “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilise the government’s medium-term debt dynamics.

“More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.”

The agency said it might lower the US long-term rating another notch to AA within the next two years if its deficit reduction measures were deemed inadequate.

S&P noted that the bill passed by Congress this week did not include new revenues – Republicans had staunchly opposed President Barack Obama’s calls for tax rises to help pay off America’s deficit.

The credit agency also noted that the legislation contained only minor policy changes to Medicare, an entitlement programme dear to Democrats.

“The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed,” it added.

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Moneychangers see sluggish trade in US dollar

By QISHIN TARIQ qishin.tariq@thestar.com.my

PETALING JAYA: Trade in the US dollar has been sluggish over the last week for moneychangers as customers “wait and see” which direction the currency will go.

“It has become a waiting game as people look for the best time to buy.

“Now, even trade in euros has slowed down,” said moneychanger Sahul Hamed, who operates the PJ Forex outlet at Bukit Bintang Plaza in Kuala Lumpur.

“With the current economic situation, customers are expecting the value to dip but are reluctant to buy when they feel it hasn’t gone down by much.”

Anxious wait: The demand for US dollars could spike with a potential fall in the currency’s value following the downgrading of the US credit rating on Friday.

Moneychanger Jamil Akhbar Ali said there had been a dip in both sales and purchase of the US dollar despite the stable value of the currency over the last week.

“Most of our customers deal in Singapore and US dollars.

“While trade in the Singapore currency remains about the same, there are fewer people trading US dollars,” said the Petaling Jaya-based moneychanger.

Automotive engineer Meng Ng, 35, a Malaysian based in the United States for the last decade, said the exchange rate had not changed much since he last came to Malaysia four months ago.

“While the prices offered by moneychangers fluctuate slightly every day, on average the exchange rate has been pretty reasonable,” he said.

With the worsening US debt outlook and after US-based credit rating agency Standard & Poor’s downgraded the US credit rating on Friday, speculation was rife that the US dollar would weaken considerably.

RAM Holdings Bhd group chief economist Dr Yeah Kim Leng said while the US currency would probably dip in the short term, he expected it to recover fairly quickly.

“When Japan’s credit rating was downgraded from AAA status to AA+, its debt market was hardly affected with bond yields remaining relatively unchanged,” he said.

“The weakening US dollar would make imports from the country cheaper not only for large industries, but even for something as small as an online purchase.

“It’s a double-edged sword though, as the US will lower its demand and import less when its economy is going through a soft patch.”

Trade in renminbi, says FMM

By YUEN MEIKENG  meikeng@thestar.com.my

PETALING JAYA: Malaysia should consider trading in a different currency from the US dollar, such as the Chinese renminbi, to avoid being affected by the dollar’s devaluation.Federation of Malaysian Manufacturers (FMM) president Tan SriMustafa Mansur said people had to accept the fact that China was poised to be the largest economy in the world.“We also export a lot to China and our business with the country has grown substantially since the enforcement of the Asean-China Free Trade Agreement,” he said yesterday.Mustafa said many countries, which traded using the US dollar, including Malaysia, would stand to lose out as its exports would have a lesser value following the currency’s downgrading.

“Based on this situation, we might have to look into the possibility of trading in a different currency,” he said.

Mustafa said this when asked to comment on the United States losing its coveted top AAA credit rating and its impact in Malaysia.

It was reported that credit rating agency Standard & Poor’s downgraded the nation’s rating for the first time since the US won the top ranking in 1917.

Mustafa added that it was also better for Malaysia to trade in ringgit as this would distance the country from any risk of further downgrading of the US dollar.

He said other currencies, which could also replace the US dollar were dinar, dirham or the Japanese yen.

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Washington and the Art of the Possible

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Raghuram Rajan

CHICAGO – These days, the United States media are full of ordinary Americans venting their rage at the incompetence and immaturity of their politicians. Even though the US government’s debt limit was raised in the nick of time, the process was – and remains – fraught with risk. Why, the public asks, can’t politicians sit down together like sensible adults and come up with a timely agreement that commands broad consensus? If we can balance our household budgets, they ask irately, why can’t our political leaders?

The reality, though, is that US politicians reflect the views of the American electorate – views that are fundamentally inconsistent. The absence of broad consensus is no wonder. Indeed, the last-minute agreement to raise the debt ceiling is proof that the politicians did what they were sent to Washington to do: represent their constituencies and only compromise in the interests of the country as a whole.

The key question is whether the political gridlock exposed by the debt-ceiling debate will worsen in the run-up to the 2012 presidential and congressional elections – if not beyond. That is possible, but we should not overlook cause for hope in what America’s politicians just accomplished.

Let’s start with why the electorate is so polarized. There are two key divisive factors: income and age. Income inequality has been growing in the US over the last three decades, largely because the labor market has increasingly demanded skills that the education system has been unable to supply. The everyday consequence for the middle class is a stagnant paycheck and growing employment insecurity, as the old economy of well-paying low-skilled jobs with good benefits withers away.

Until the financial crisis, the easy availability of credit, especially against home equity, enabled the middle class to sustain higher consumption despite stagnant incomes. With the collapse of the housing bubble, many people lost their jobs and health insurance, risked losing their homes, and suddenly had little reason for economic optimism. The response from America’s Democratic Party, which has traditionally represented this constituency, was to promise affordable universal health care and more education spending, while also protecting government jobs and entitlement programs.

When added up, such spending is unaffordable, especially with current federal revenues at just 15% of GDP. The solution for many Democrats is to raise revenues by taxing the rich. But the rich are not the idle rich of the past; they are the working rich. To balance the budget only by taxing the rich will require a significant increase in income taxes, to the point that it would lower incentives for work and entrepreneurial activity considerably.

This is not to say that taxes on the rich cannot be increased at all; but such increases cannot be the primary way of balancing the budget. Republicans, trying to give voice to many working Americans’ ambient uneasiness with rising government expenditures, as well as to the growing anger of the working rich, find it easier to defend a principle than a particular constituency. Hence their mantra: no additional taxes.

The neat divide based on income is muddled by the elderly. It is understandable that older Americans who have few savings want to protect their Social Security and Medicare benefits. However, even elderly Tea Party Republicans, who are typically against big government, defend these programs because they view them as a form of property right, paid for when they worked.

In truth, rising life expectancy and growing health-care costs mean that today’s elderly have contributed only a fraction of what they expect to receive from Social Security and Medicare. The government made a mistake in the past by not raising taxes to finance these programs or reducing the benefits that they promised. Unless the growth of these entitlement programs is curbed now, today’s young will pay dearly for that mistake, in the form of higher taxes now and lower benefits when they are old.

But the elderly are politically active and powerful. Not only do many defend their entitlements strongly; some oppose growth in other types of public spending for fear that it will weaken the government’s ability to pay for the benefits that they believe they are owed.

These then are the roots of America fiscal impasse, which has produced passionate constituencies viscerally opposed to compromise. Any political deal significantly before the debt-ceiling deadline would have exposed politicians to charges of betrayal from their constituents. And, given that President Barack Obama would ultimately be held responsible for a default, he needed the deal more than the Republicans did. So he had to coerce his party into accepting a deal full of spending cuts and devoid of tax increases.

Will the deal deliver what it promises? A bipartisan committee has to propose $1.5 trillion in deficit reduction by the end of this year, and Congress must either accept that proposal, or see immediate, politically painful expenditure cuts, which would include defense spending – an area that America’s Republicans care about strongly.

If this structure works as advertised, Congress will be forced to reach a compromise, which can be sold once again by politicians to their polarized constituencies as being necessary to avoid a worse outcome. This time, Obama’s Democrats will be on a level playing field, because both parties will be held equally responsible for a failure to reach a deal.

Ultimately, the big necessary decisions on curbing entitlement growth and reforming the tax code will probably have to wait until after the next election, giving the divided electorate an opportunity to reflect on its own inconsistency and send a clearer message. In the meantime, US politicians might have done just about enough to convince debt markets that America’s credit is still good. For that, Americans – and others around the world – should stop pillorying them and give them their due credit.

Raghuram Rajan, a former chief economist of the IMF, is Professor of Finance at the University of Chicago’s Booth School of Business and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy, the Financial Times Business Book of the Year.

US Debt deal reached to avoid default, what others are saying?

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What China, Others, Are Saying About US Debt Deal?

Debt ceiling raised…again.

President Barack Obama said Sunday night that both houses of Congress finally reached an agreement to reduce the budget deficit and avert a debt default that would have likely sent the country into a recession.

“Leaders of both parties, in both chambers, have reached an agreement that will reduce the deficit and avoid default — a default that would have had a devastating effect on our economy,” Obama said in his remarks to the White House press Sunday shortly after the bill was signed. The first part of the debt deal cuts nearly $1 trillion from the federal budget over the next decade. Exact details were not immediately available.

“The result would be the lowest level of annual domestic spending since Dwight Eisenhower was President,” Obama said. The debt limit and cut spending between $2 trillion and $3 trillion.

The Economic Times of India polled readers who said overwhelmingly that the Indian market would be impacted on Monday as investors in the US digest this weekend’s news. A total of 85% of the paper’s readers polled on line said it would impact India’s market all week.

Russian newswire columnist Andrei Fedyashin said recently, before Sunday’s deal, that “cuts in social spending and higher taxes are still the only way of reducing budget expenditures and a country’s sovereign debt.”

Yao Yang, director of the China Center for Economic Research at Peking University, weighed in at China Daily. He said that the US deficit problem “is ultimately the result of the conundrum of a welfare state following the capitalist system. Both are uncompromising ideals cherished by a substantial percentage of the population. The fight will resurface in the future even if the present deadlock is broken. There is a lesson for other countries here. The best a country can do is to fence off the contagious effects of such fights and rely more on the domestic economy for further growth.”

Also reprinted in China Daily, Mohamed El Erian, CEO of PIMCO, says, the next few weeks will provide plenty of political drama. “The baseline expectation, albeit subject to risk, is that Democrats and Republicans will find a way to avoid disruptions that would damage the fragile US economy, but that the compromise will not meaningfully address the need for sensible medium-term fiscal reforms.”

In Brazil, an article in Folha de São Paulo, the country’s largest daily newspaper, said that Americans woke up too late to its serious spending problems. Not only government spending, but consumer spending as well. A foreign correspondent for the paper interviewed US think tanks and scholars who said that the average US citizen was “uninformed” about the country’s economy and pending debt crisis. Despite having nearly every country south of Texas run into similar debt dead ends, the US — printers of the world’s reserve currency and the largest economy — didn’t seem to flinch when society, and government, became overweight with debt. The US is in a unique world situation because of its status as world’s reserve and trade currency, and issuers of the most trustworthy debt in the market.

“Americans are not well informed about the economic crises that occurred in other countries to learn from them,” said Isabel Sawhill, an analyst from the Brookings Institute in Washington. “They don’t see any parallels with crises in other countries because they think the US has the capacity to resolve all problems. The population knows there is a problem, they just don’t know to what extent or where it comes from.”

Linda Bilmes, a former government consultant turned Harvard lecturer in Cambridge, the main problem with the debt deal is taxes and political ignorance over tax laws. “The biggest reason our debt is so high is because George W. Bush cut taxes two times exactly when we were spending money on two wars,” Bilmes told Folha. “In the last two major US wars, taxes went up to support those expenditures.”

See: White House, Congress Reach Debt Deal

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Frantic US debt talks!

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Frantic US debt talks resume

Oliver Knox

White House talks on averting a disastrous debt default have resumed and are closing in on a compromise with just three days to act, says US President Barack Obama’s top senate ally.

Democratic US Senate Majority Leader Harry Reid has put off a contentious procedural vote on a White House-backed plan to avert a disastrous debt default, citing progress toward a compromise.

“There are negotiations going on at the White House to avert a catastrophic default on the nation’s debt,” said the Democrats’ Senate leader Harry Reid in a late-night announcement on Saturday.

“There are many elements to be finalised and there is still a distance to go.”

Obama, his Democratic allies and his Republican foes have been hunting for a breakthrough deal that would ensure the world’s richest nation will have cash to pay its bills past next Tuesday’s deadline.

Reid said that, at the White House’s request, he was putting off until Sunday afternoon, Washington time, a test vote on his own plan to raise the $US14.3 trillion ($A13.03 trillion) American debt ceiling to allow time for a possible compromise.

“They’ve asked me to give everyone as much time as possible to reach an agreement – if one can be reached,” Reid said.

“I’m glad to see this move toward cooperation and compromise. I hope that it bears fruit,” said Reid, who said he was “confident” that a final deal would embrace a long-term increase in the US debt ceiling.

The US economy hit the debt limit on May 16 and has used spending and accounting adjustments, as well as higher-than-expected tax receipts, to continue operating normally – but can do so only through August 2.

Business and finance leaders have warned that default would send crippling aftershocks through the fragile US economy, still wrestling with stubbornly high unemployment of 9.2 per cent following the 2008 global meltdown.

Without a deal, the US government will have to cut an estimated 40 cents out of every dollar it spends, forcing grim choices between defaulting on its debt or cutting back on programs like those that help the poor, disabled and elderly.

Any compromise would still need to clear the divided Democratic-led Senate and Republican-held House of Representatives, where conservatives close to the Tea Party movement have called for draconian belt-tightening.

Reid’s announcement came after Obama called him and Democratic House Minority Leader Nancy Pelosi to an urgent White House summit with Vice-President Joe Biden and spoke by telephone to top Senate Republican Mitch McConnell.

McConnell declared himself “confident and optimistic that we’re going to get an agreement in the very near future” and predicted that most Democrats would “fall in line” behind any deal the president cut with Republicans.

Republican House Speaker John Boehner said in a joint press conference with McConnell on Saturday that they were both confident that “we’re going to be able to come to some agreement with the White House and end this impasse”.

Reid had poured cold water on the upbeat Republican message, bluntly telling McConnell that talk of a looming deal was “not true” and insisting that “merely saying you have an agreement in front of television cameras doesn’t make it so”.

Hours later, Reid changed his tune and announced he was putting off a test vote during the weekend aimed at ending the crisis.

Senate Republicans had been expected to kill the measure, citing what they considered to be insufficient guarantees of steep spending cuts to offset the increase in the US national debt.

Details of the burgeoning accord were not immediately available but Reid said he was “confident” that a final deal would meet Obama’s condition of putting off another debt fight until after his November 2012 re-election bid.

Earlier, aides said key points of contention included the overall size and makeup of spending cuts, and the creation of a special committee of congressmen and senators tasked with finding more savings in the near future.

They also included a fight over an enforcement mechanism to ensure that the new panel agrees to future spending cuts, notably to cherished social safety net programs, according to a senior Republican senate aide.

It was unclear whether the deal would be enough to talk ratings agencies from downgrading the sterling Triple-A US debt rating, causing a lift in interest rates that would throw a wrench into the gears of the already sputtering US economy.

The acrimonious talks came after the Republican-led House of Representatives voted to kill Reid’s proposal for raising the debt limit, a day after the Democratic-held Senate did the same to Boehner’s plan.

© 2011 AFP

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