In early August, the U.S. Congress, after weeks of intense discussions, was finally able to agree on a debt deal. The deal will raise the U.S. debt limit by at least USD 2.1 trillion and significantly cut federal spending in coming years. Agreed spending cuts will amount to at least USD 917 billion over the next ten years. On top of that, a congressional committee will work out a plan that would cut the deficit by an additional USD 1.5 trillion. The additional funding provided with the increase of the debt limit should give the U.S. government enough funding to operate until 2013, this means that after the next election a new debt deal needs to be made. It was a very intense battle between Democrats and Republicans and the possibility of a debt default created a lot of uncertainty in recent weeks. This uncertainty was felt very directly in financial markets and caused global stock markets to move lower and the U.S. Dollar to lose further ground against most major currencies. With the debt deal now in place, can we expect a recovery rally in the weeks ahead and hope that everything will be just fine again? What is needed to improve things to the better in the long-run?
US Dollar Index
Unfortunately, there are a lot of factors that suggest that we have to be prepared for more market volatility and economic uncertainty. The problem is, in my opinion, not so much the debt limit and the spending cuts that now have been agreed. The main problem is that the latest battle about the debt limit has caused severe damage to the confidence international investors have in the U.S., this comes at a time when the need for foreign investment and capital is bigger than ever before. Also it seems that neither Republicans nor Democrats are truly happy about the deal negotiated, although each party tries to sell it as a victory, but clearly for Republicans the spending cuts are not enough and Democrats are not happy because there are no tax hikes included in the deal. While the problem can be viewed from different angles, it was the actual public debate about how to solve the debt limit problem that is causing real economic damage. For a few weeks, investors around the world kept their eyes on the U.S. debt crisis and the political fight about it. Raising debt limits is something that has happened many times in the past few decades. Just since the early 60’s, this happened more than 70 (!!) times and most of the time it was not a big deal…BUT…this time it is a different situation. The sheer debt number, which has now exceeded USD 14 trillion is scary enough, but it always needs to be seen in the overall context, that means in comparison to the size of GDP and here the story gets really alarming. The size of the overall federal debt has now exceeded the size of GDP and continues its strong upward trend and is now approaching levels not seen since the late 40’s. In the 50’s, 60’s and 70’s the size of the debt burden fell to levels of less than 40% of GDP but since the early 80’s, this trend has reversed. The only time since then when the debt level (as percentage of GDP) was falling was in the late 90’s, primarily driven by strong economic growth.
The current debt level ranks among the highest in the world, of course there are other nations which look even worse, for example Japan (225%) or economic heavyweights such as Saint Kitts and Nevis (185%), Lebanon (150%) or Jamaica (123%). Other major economies such as Germany and France do not look much better with debt levels of around 80%. The difference to a country like Japan is that most of their debt is being held by Japanese investors, therefore they are able to finance that debt domestically. Also recently, China has started to make significant investments in Japanese government bonds while cutting back heavily on its purchases of U.S. treasury bonds, a further indication that investors are becoming reluctant to buy additional U.S. debt. Despite the fact that the U.S. debt deal is a step in the right direction, the problems are far from over. The deal reached now is not perfect, it seems like neither Republicans nor Democrats are really happy with the deal, but it was the best possible compromise that could be made given the current circumstances, but in the future further spending cuts will need to be made and the debate about future tax increases will most likely be the next big battle in Washington. The problem now is that the increased spending cuts will hurt the economy even further at a time when the economy is not able to generate enough jobs and prevent the jobless claims from going up. Also private households are in a long-term process of deleveraging, which will keep consumption growth at moderate levels. In order to bring down the unemployment rate, the economy would need to grow at a rate of at least 3.5%, right now it looks like GDP growth is going to drop below the 2% mark in the near future, possibly dropping back to zero later next year. A lackluster economy will also result in lower tax income which will make it harder for the government to service their debt.
So how can this problem be solved? Is it even possible to do something about it? In my opinion the answer is YES. This situation can be improved dramatically in the next ten years, IF Republicans and Democrats work together to define and execute a plan which makes sense economically and truly works in the best interest of the people. The problem with the current discussion is that very few people differentiate between spending and investment. Investment means spending money on something that adds true economic value over time. People are willing to pay taxes, but they need to see benefits for it in return. Foreign investors will keep lending money to the U.S., but they need to see that this money is spent wisely and not just wasted. Let’s for example look at the enormous cost of defense. The U.S. is currently spending about USD 700 billion per year for its armed forces. In total, the wars in Iraq and Afghanistan have cost almost USD 3 trillion in recent years and as per the end of 2010 almost 5% of GDP were defense related spending.
Figures based on 2010 budgets (SIPRI)
It is more than 10 times what Russia spends on defense, although in terms of percentage of GDP, also Russia spends more than 4%. Most major countries today spend between 1.5% and 2.5% for its armed forces.
It is therefore not surprising that a big portion of the now agreed spending cuts come from defense but even after these cuts the amount of money spent here are enormous. It is understandable that a growing number of Americans are not in agreement with this spending policy and feel that money should be better used to improve things at home rather than spending it on wars in countries like Iraq and Afghanistan. While the U.S. is spending too much in some places, it is not investing enough for other items, especially infrastructure related projects. Infrastructure is the kind of investment that tends to truly add economic value in the long-run and provide benefits for everybody. Clearly, looking at the condition of today’s infrastructure (roads, bridges, electricity grids) it becomes obvious that there is tremendous need for such investments. Also, finding investors for such projects will be a lot easier.
What the United States needs is a sound long-term economic development plan, much like the Marshall Plan in the late 40’s. It has got to be a sound economic development plan that cuts spending in areas that do not make sense economically and encourage spending in areas that result in true economic value long-term (infrastructure, education, etc.) and such a plan needs to be supported by both major political parties. The investment spending created through such an economic development plan would immediately provide benefits for everybody, increase economic activity and therefore also create jobs and eventually increase tax revenues without the need to hike rates. In order to work out and implement such a plan, Republicans and Democrats need to work together for the benefit of all Americans.