The American Way

When America sneezes, the rest of the world catches cold. This used to be one of the elements of conventional wisdom about global economic policy in the postwar era. It highlighted the overwhelming dominance of the world economic powerhouse, something that has only come to be seriously questioned during the current economic crisis. Now, however, echoing the dramatic eastward shift in the global balance of economic power, the erstwhile admiration for America has given way to persistent and profound criticism.

In particular, key elements of the US economic policy are increasingly viewed as unsustainable, potential threats to the one-time economic dominance of the country. This month’a mid-term elections highlighted the fact that much of the US electorate share this frustration. The elections resulted in a resounding Republic victory, highlighting the inability of the Obama administration to bring about a sustainable economic recovery but also the growing concerns about the deteriorating fiscal position of the US government. In spite of the palpable anger, the elections left the balance of power in the legislative branch split with the Senate still remaining in Democratic hands. Even as markets have welcomed the Republicans’ verbal support to fiscal consolidation, it is far from clear to what extent the two sides can work together effectively.

Even as the historic mid-term elections echoed the Republican triumph of 1994, the magnitude of change was even greater with a projected gain of possibly more than 60 seats (as compared to 52 in 1994), ahead of anything seen since the 1948 landslide. In spite of the continued Democratic control of the Senate, the Republicans will now have sufficient votes to filibuster – essentially torpedo – new legislation. Even more problematically, the new Congress will be not only divided but quite possibly more polarised than has been the case in a long time, possibly ever. Nonetheless, a refocusing of political priorities seems almost certain after this political earthquake. A remarkable 80 per cent of the electorate claimed to be primarily motivated by worries about the economy. President Obama has voiced recognition of the changed national mood and promised to cooperate with the new Republican House majority. However, the exceptional ideological divergence may make a period of effective deadlock unavoidable.

The Republicans have generally vowed to work for fiscal consolidation and a smaller government. Come what may, additional fiscal stimulus measures by Congress are very unlikely. While the two sides are likely to seek common ground on at least some key matters, it is likely that the Republicans will seek concessions on salient issues, something that may call elements of the Obama program in questions. Among other things, the Republicans have threatened to undermine the implementation of the health care reform as well as of some of the stimulus measures adopted by the administration. An early resort to a presidential veto might quickly sour to mood and lead to open confrontation, much as happened in the mid-1990s before the two sides eventually changed course. The current economic crisis makes such a delay far riskier.

As the prospects for fiscal policy changed dramatically, the Federal Reserve offered continuity on monetary policy, justifying its actions in part by the absence of significant inflationary risks. It actually deemed the current level to be low from the perspective of its dual mandate. Broadly in line with market expectations, the Federal Open Markets Committee last Wednesday announced a $600 billion package of quantitative easing, to be completed by the end of the second quarter of 2011. The Federal Reserve Bank of New York stated will seek to buy securities with average maturities of 5-6 years while temporarily relaxing its 35 per cent per issue purchase limit. The Fed will also continue to reinvest early repayments from its portfolio of mortgage-backed securities.

The continued quantitative easing highlights mounting frustration with the slow pace of economic recovery. Even though unemployment has stabilised, it is stuck at close to 10 per cent. Consumer spending has been subdued as Americans seek to rectify their balance sheets through de-leveraging following a dramatic decline in their asset portfolios, notably their homes. The exact future trajectory of QE remains in considerable doubt, however. Some commentators had expected a far larger and more open-ended program, potentially totaling $1.5bn or even $4.0bn. However, the FOMC merely reiterated its readiness to review and adjust the program “as needed to best foster maximum employment price stability” after the end of the second quarter of 2011. This constitutes a major element of uncertainty in the face of the widely expected fiscal consolidation and the ongoing de-leveraging by households.

The Fed’s actions are likely to have significant market implications at a time when the Bank of England and the European Central Bank reiterated their current monetary policy stance, something that helped push the exchange rate of the Dollar back to its 2008 levels. A period of Dollar weakness in turn creates a prospect of tit-for-tat as QE can easily turn into old-fashioned protectionism in a new guise. Paradoxically, however, it also risks perpetuating some of the imbalances in the global economy. QE is helping support the weaker European economies by supporting the value of the Euro, barring a major deterioration in the European sovereign debt crisis, and creating liquidity in search of higher returns provided by the eroding credit worthiness of the more vulnerable European sovereigns. Moreover, an emerging market bubble risks undermining one of the few relative success stories of the crisis. At the same time, other major economies with floating currencies will struggle if a weaker Dollar kills their export-led recoveries.

Additional quantitative easing was widely expected by the markets and it has been one of the drivers of the recent improvement in market sentiment. In general, QE can be expected to depress the prices of low-risk assets and forces investors to seek higher returns through riskier positions. Similarly, the low cost of borrowing is bad news for economic efficiency. It gives banks little incentive to move up the risk curve but it also allows inefficient organisations to survive as their borrowing costs become more manageable. The Fed’s actions present a particular risk because of their inherently anti-cyclical nature at a time of a major structural crisis. If the structural remedies continue to be delayed, no amount of painkiller will suffice, as the Japanese example should remind us. In the absence of real structural reform, the Fed’s efforts can easily produce more distortions then relief. Among other things, the higher commodity prices resulting from QE2 can easily increase inputs costs and erode the strength of the recovery. A permissive Fed must not become an excuse for inaction by the executive branch.

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