Indian Express, 11 August 2011
The credit rating agency Standard & Poor's downgraded US soverign ratings from AAA to AA+ after the US government failed to agree on a path of fiscal consolidation. On August 5, the US Congress voted to raise the debt ceiling of the US as required by the Public Debt Acts. The agreement reached among political parties in the US was to inflict no pain until the end of 2012. The lack of fiscal tightening indicated the difficulties America has in arriving at a political consensus for reducing the fiscal deficit. The political discourse that preceeded the last-minute increase in the federal debt ceiling undermined the credibility of the US government's commitment to deficit reduction and contributed to the downgrade. Fiscal analysis was the other component.
Markets, however, continue to have faith in the US government and its ability to service debt without default or inflating its debt away. For the same fiscal situation and lack of a clear path of fiscal consolidation, another country may not have had the same trust of markets. The lack of alternative safe and liquid assets implies that the markets continues to see US securities as safe assets. The downgrading is thus unlikely to have people start thinking that the US government is going to default on its debt and holding of US government bonds is unlikely to go significantly down.
At the same time, Europe is also facing immense difficulties. Soverign ratings of UK, France or Germany continue to be AAA for the moment. But is the fiscal scenario for these governements any better than that of the US? In 2010 the deficit to GDP ratio of UK was above 10 percent. Owing to the recent crisis and the action taken by the government, its debt to GDP ratio climbed to 80 percent of GDP, somewhat less that that of the US which stood above 91 percent. The crucial difference however appears to be a tight fiscal policy put in place since May 2010 by the Conservative-Liberal coalition. If GDP growth slips or if the strategy of fiscal austerity is compromised, the credit rating of the UK would fall again. At the moment, there is support for austerity, but if the London riots lead to rethinking about benefit systems and ways to tackle unemployment, this policy could change as well.
France is however in a much more precarious position than the UK. France not only has a high public debt of 82 percent, and a high defict of 7 percent, there is no support for fiscal consolidation. After the US downgrade, markets expect France to be the next country to see a downgrade. This is reflected in the market for credit default swaps of France which rose sharply this week.
The German economy with fiscal deficit at 3 percent and public debt at 83 percent is seen to be the healthiest eocnomy in Europe. There is popular support for a tight fiscal and one would have thought that even if weaker European nations get into trouble, Germany would be safe. The recent purchase of Spanish and Italian bonds by the ECB pose a danger to this story. If the ECB gets into trouble and Germany has to bail it out, the German fiscal situation would be in as much trouble as France. It is difficult to see how the German government would continue to get popular support for keeping German and European banks afloat through buying poorly rated European bonds if the German tax payer has to ultimately pay.
The downgrade of US and eventually of Europe is a measure of the unsustainable nature of the fiscal policies of these governments. It is sometimes argued that the fiscal expansion in a balance sheet recession is a good thing. A balance sheet recession, such as the one being witnessed in the US today, is one where households and firms are de-leveraging and contracting expenditure. At such a time, fiscal expansion is necessary to offset the contraction in demand that is happening through private spending. This means that instead of seeing it as a negative, fiscal expansion should be seen as a positive. The system of ratings, it is argued, should be different, in a balance sheet recession, so that that rating does not become a stick to beat the government with. This view argues against a fiscal contraction at the time of a recession. In the case of the US, since it seems that the economy is unlikely to come out of the recession for another 2 years, it would be wrong to start contracting government demand. Even if the deficit leads to inflation, this, to some extent may not be bad for the economy. This is perhaps one reason why despite the downgrade there has been no significant shift away from the dollar. The fact that the dollar is a reserve currency and the US government can issue more dollars allows the US government more leeway to run large deficits than, say, an Indian government would have been able to do.
The downgrade and the political discourse in the US has had the effect of increasing uncertainty in the world. An increase in uncertaintly is often accompanied by an increase in risk aversion. This leads to a reduction in money invested in emerging economies, usually perceived to be more risky than the US and Europe. This could mean a reduction of foreign investment flowing to emerging economies, including India.
The failure to reach a consensus on fiscal consolidation is also a reflection of the need for the US economy for continued fiscal stimulus. Ben Bernanke has indicated that markets should expect to see two more years of expansionary US monetary policy. This again indicates expectations of weak growth. Lower growth in US and Europe would mean lower growth for the rest of the world, including emerging economies and Europe. India cannot be cut-off from a global slowdown and is likely to see difficult times ahead.
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