[Mb-civic] Buttonwood Close, but no cigar Economist

Wed Nov 3 10:28:58 PST 2004

Buttonwood 

Close, but no cigar

Nov 3rd 2004 
>From The Economist Global Agenda

Same president, same soaring deficits, same market worries?

SO THE votes have been mostly counted and George Bush has been elected for a
second term as president. No political analyst, Buttonwood leaves the
possible socio-political consequences of his re-election to those with more
expertise. What, he wonders, will be the effects on financial markets? In
the run-up to the election, there was much speculation about what the
election of either John Kerry or Mr Bush would mean for financial markets.
Worst of all, thought many commentators, was the possibility of a re-run of
2000, only more so: that not just Florida but a handful of states might be
snarled up in legal wrangles at a time when leadership of the world¹s
biggest economy is sorely needed.

As it turns out the election, though close, was not nearly as close as many
had feared. That has clearly relieved many investors. Stockmarkets (the
risky investment) popped up a bit; government bonds (the safe-haven
investment) fell a bit; and the dollar rose a very little bit. Possibly,
too, this was something of a vote for Mr Bush. Even though the stockmarket
has done dismally over the past few years and stockmarkets have historically
done better under Democratic presidents, Mr Bush has been seen as more
favourable to the stockmarket this time round, largely because of his record
of individual and corporate tax cuts, and because he wants to make permanent
many of these reductions. Mr Kerry, in contrast, wanted to scrap some of
them. Well, perhaps, at the margin, there may have been some differences
between the two candidates, though Buttonwood has searched in vain for
anything approaching coherence in either platform. But neither candidate,
certainly not Mr Bush, was prepared to address what is, bar perhaps the
terrorist threat, the most serious of all the questions facing the long-term
prospects for the American economy, and by extension the stock and bond
markets: the rising tide of red ink that is washing over it.

 That tide has risen at a fearful pace in part because Mr Bush¹s huge tax
cuts have been matched by similarly huge spending. Thus has the government
fallen ever deeper into debt. Early in 2001, the Congressional Budget Office
(CBO) had predicted a budget surplus over the ensuing ten years of $5.6
trillion. It was in order to return some of this projected surplus to those
who had earned it that Mr Bush originally proposed his tax cuts. Financial
markets even pondered a life‹how long ago this now seems‹without Treasury
bonds.

In its latest outlook, in September, the CBO predicted a deficit over the
next ten years of $2.3 trillion. But that projection assumes, among other
unrealistic assumptions, that most of the tax cuts are allowed to expire.
With Mr Bush back in the Oval Office, that hope will almost certainly prove
as optimistic as right-thinking people thought it was in the first place. Mr
Bush has said that he wants to halve the deficit, but nothing he has said or
done, nor any half-baked plan that he has come out with, gives any cause for
hope on this score whatsoever. Independent number-crunchers think that the
deficit over the next ten years will be $5 trillion-$6 trillion‹more than
twice the CBO¹s estimates.

Nor have Americans proved any less spendthrift than their leader. Their
habit has also been financed largely by debt, which has risen remorselessly.
Since 1998, households¹ debts (from mortgages to credit-card balances) have
risen from 90% of their annual disposable income to some 114%, a record
high. As a result, almost a fifth of household incomes are now spent on
servicing these debts, not far off another record. And the latter figure is
all the more troubling when you consider that, with a Fed Funds rate of
1.75%, short-term interest rates are still pretty close to historic lows and
long-term rates are pretty meagre, too. It used to be that this did not much
matter, because home-buyers borrowed long term and at a fixed rate. In
recent years, however, they have taken advantage of the sharp difference in
short- and long-term rates to shift to floating-rate borrowing. Much of this
borrowing has been used to finance the purchase of property that is, by any
historic yardstick, very expensive.

These huge and growing debts show up in the country¹s huge and growing
current-account deficit, which is now close to 6% of GDP and shows no sign
of shrinking. Were America an emerging economy, warning lights would be
flashing red and investors would be rushing for the exit. But so far
investors from other countries have been happy to finance this deficit.

In the past, most of the appetite for dollars came from private investors.
Recently, however, private demand has evaporated, and the dollar has been
supported by gargantuan purchases from Asian central banks anxious to keep
their currencies from rising too much against the dollar. Since 2001, the
foreign-exchange reserves of Asian central banks have increased by $1.2
trillion‹or about two-thirds of America¹s accumulated deficit over the
period. These purchases have kept the dollar stronger than it would
otherwise have been and American interest rates lower. Foreign central banks
will not carry on financing this deficit for ever. But what will happen to
the dollar, to interest rates and to the American economy when they stop?

On these questions Buttonwood finds it hard to be sanguine. A good outcome
would be a gentle but sustained fall in the dollar. A bad outcome would be a
dollar crisis. Even then, bond yields might stay relatively low because of
disinflationary pressures, but Buttonwood has no certainty about this: they
could rise sharply because of a general shunning of dollar assets.
Short-term interest rates might have to rise, again sharply, to attract the
necessary saving. A combination of lowish long-term bond yields and much
higher short-term rates would hit corporate profits hard, because perhaps
half of them come from financial firms of one sort or another, and financial
firms benefit hugely when short-term rates are much lower than long-term
ones. Sharply higher rates would also bring an economy laden with debt to a
juddering halt. Demand would shrink as consumers saved more. This would also
hit corporate profits hard, presumably bringing an overvalued stockmarket
down with them. Defaults, both individual and corporate, would increase. Bad
debts would rise at banks; yields on riskier bonds, which have fallen to
extraordinarily low levels, would rise sharply.

That, admittedly, is perhaps the gloomiest scenario, though it doesn¹t even
mention an escalation of the worsening problems in the Middle East, nor
another terror attack. It may not happen, it may happen slowly, or America¹s
nine-lives economy may carry on muddling through: it is, after all, humming
along quite nicely at the moment. But the re-election of Mr Bush does
nothing to ease Buttonwood¹s long-term fears. That would take an
administration with far greater intellectual clout and economic literacy
than the bunch that has just kept control of the White House.

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