State of the Union

In my recent two-part discussion with Banphot on The Money Channel, we discussed our alternative assessment of the state of the American union, turning to the political risks and issues: - 

We all saw the annual State of the Union speech on TV for the American people, but we actually read an alternative State of the Union by Nouriel Roubini, the economics professor, who put some thing together that he published in the last few days that for me is a much better description of the State of the Union of the United States at the moment. He described what he thought were seven major problem areas whereby American economic performance is really just papering over the cracks, and what we're seeing is just hiding all the problems that are underneath there, and it's actually a lot of things that we've been saying for some time now.   

He was talking about the fact that there's a $15 trillion debt that's just not going away, and what's more, there's a deficit every single year as well, so that debt is just increasing. Like us, he doesn't really believe that American economic performance is picking up, and even though we saw some better numbers coming through for some of the Q3 and provisional Q4 results, but we had Operation Twist in the second half of last year, and that really forced a lot of stimulus, a lot of impetus into the economy. It came with a very large cost as well with all this long-term debt being swapped for short-term debt, so it came at a large cost but that had an impact on the economy, but to us that's not real growth; it's a one time benefit. Unlike QE I think the benefit of operation twist was that it had an impact on the real economy rather than just on financial assets. It's better than QE but it still has the same fundamental problem as QE, which is that the first time you do it, you get quite a big impact, but after that, you always get diminishing returns, so they might do a second Twist, a third Twist. They're talking about QE3. They're talking about buying residential mortgage-backed securities, commercial mortgage-backed securities. They're talking about all these other forms of stimulus that might happen, but the problem with all of them is that even if they do have a positive impact, it's inevitably decreasing.  

QE1 had a positive impact on the financial markets. It didn't really have an impact on the economy, but it had an impact on the stock markets, but QE2 was a much more limited impact over a shorter period of time, and we think that QE3 therefore wouldn't be so great, and then QE4, QE5 even less so. Eventually you end up having no real impact. We might get a second and a third Twist, but each time the impact will be smaller and smaller and smaller. We don't really think that these things are in any way a fix, and again we agree with Nouriel Roubini in that the real problem is still there. Roubini describes it as two kinds of deficit problem. One is that there's a stock problem i.e. there's $15 trillion of debt already on the US federal balance sheet, and you have to do something about that because the cost of servicing that debt doesn't go away. The second problem is what's called a flow problem i.e. are you actually paying off that capital every year or are you increasing it. Well America has both problems; it has a huge amount of debt, approximately 100% of GDP, and it's getting worse every single year, and no one really seems to have come up with a solution to that. In America, a lot of the State of the Union was political posturing; it was Obama putting himself in front of the American population as a great advert for a re-election campaign with elections coming up at the end of the year.   

We've really got a choice in the States with a Democrat party that believes in raising taxes for the very rich, which we agree with – it needs to happen. Income in the States is so badly distributed that it's all sticking in the top echelons. It's not circulating into the economy. It's stuck on corporate balance sheets, and corporates aren't employing people, so again it's not circulating; it's not having any economic utility. So we see the democrats saying they need to tax that, but they're not prepared to cut the running costs in the economy, so there's no way you can generate enough extra revenue through taxes unless you cut costs as well, otherwise we're still going to be running at an annual deficit.  The republicans on the other hand are saying they want to cut costs, but they're not prepared to raise taxes, so we have the worst of both worlds. You need to do both of these things. You need to do something to fix the stock of the debt i.e. how much debt is outstanding, and in reality we think a lot of that has to be written off; a lot of the assets have to be written off; a lot of the debt has to be written down. And you need to fix the flow of the debt as well, so you need to fix the annual deficit.

Just fixing one isn't going to solve the problem. If you somehow cut the debt but you don't stop the deficit problem, then you're just going to end up in the same situation again in a few years time. If you actually do some thing about the deficit, but you're not cutting the actual stock of debt that's outstanding, you've still got this 100% debt to GDP, and that's a real drag on economic activity and economic growth.  

I don't see anyone saying that a compromise between Republicans and Democrats is possible, and there are problems with that in that if you increase taxes and if you cut government spending, then you are going to have a fairly ugly situation; you're going to have a depression. You're going to have a very nasty prolonged recession, but unfortunately that's the only way out of the situation America is in with so much debt.  

Maybe the favourable response of some of the American population to the State of the Union speech and trying to see some positives in there, we think is a little bit of a wrong response. We think that too much of America is in denial, and they're not really facing up to how bad the situation is and how drastic the measures have to be able to get rid of that stock of $15trillion of debt that has to go away and to face up to the fact that they're running a $1.5 trillion annual deficit. They have to cut their spending and increase taxes. That will almost certainly provoke a very severe recession, going back to the depressionary days of the 1930s, but then that will allow the adjustments to happen. That will allow debt to be written off. That will allow debt to get back to manageable levels, and from that point we can grow again, and that has always been the historic cycle, but this time people are doing everything they can to delay that and kick the problem further down the road.  

Eventually you run into the situation where you just can't borrow any more. Greece has a roughly similar debt to GDP ratio as America does right now, and we're all seeing the problems Greece is having in raising money. Obviously, America's got a lot more global credibility, so we shouldn't really compare it to Greece as an economy, but that same problem will happen, but it will just happen at a higher level for America. There will come a point where borrowing money is extremely difficult, and if you can't borrow it externally then the solution is to print it.   

Printing money is inflationary as we saw in QE1 and QE2, so if you're not careful you end up in a situation where you have no growth or very low growth, and very high inflation, which means that the growth in real terms is negative, and at that point that's when the whole thing starts to implode. If politicians don't decide to adopt these policies themselves, and we can't think of any politicians who have ever decided to do the right thing and bring on a recession when it's necessary. If politicians don't decide to do that, then the markets will decide that. Now, how much longer America is able to keep things going is a really interesting point because if they keep it going all the way through 2012 then we're into the election cycle, and it may well have an impact on whether Obama manages to get re-elected or not. If it all flares up during this year, we'll see some pretty ugly effects on the market, and that will have a huge impact on Obama's re-election campaign.