European Sovereign Debt Crisis Wake Up Call for US?

By: ECR_Research

Andy Langenkamp writes: The American fiscal condition faces a perfect storm. The outlook for the medium term has deteriorated markedly. Some important causes are the Big Recession and the extension of the Bush tax cuts. Nor are the projections cheerful in the long term. In the coming period these issues will come to a head.

Two essential dates on the US political-financial agenda are approaching fast. On March 4, the spending authority that has kept the US going in the past budgetary period is set to expire. Last year, Congress did not pass a budget, and a special measure was put in place to legally underpin public spending in the absence of an official budget. This “stop-gap” bill needs to be replaced. Otherwise federal government cannot continue to spend during the remaining seven months of the fiscal year 2011.

The other looming deadline is the day the US hits its debt ceiling. By law, the US budget deficit should not exceed $14.3 trillion. It will likely reach this maximum at the end of May. To raise the ceiling would require Act of Congress.

Democrats and Republicans have climbed the barricades in preparation for the fight about these financial hot potatoes. Actually, the term “barricades” may well be misplaced. More likely, both Democrats and Republicans will dig themselves deeper into the trenches and only raise their heads above the parapet if the other party makes a significant move. Obama’s 2012 budget proposal is no more than a long wish list that offers few real solutions to the US debt problem. Its main aim seems to be to draw out the Republicans. The Democrats may be trying to divide the Republican Party (GOP) by playing off the right wing (which includes the Tea Party politicians) against the moderate conservatives in hopes of forcing the GOP to come up with iron-fisted measures that would allow the Democrats to paint the Republicans as cold-blooded and cruel.

A likely scenario is that far-reaching reforms will be deferred until after the presidential elections in November 2012. The political climate in Washington has become so poisonous and partisan that both parties fear a catastrophic outcome of the presidential election if they fall foul of the electorate. Recent opinion polls are partly responsible for this angst. A large majority of respondents expressed the wish that deficits should be curtailed whilst simultaneously rejecting cuts in specific programs.

However, the parties cannot continue to stick their heads in the sand from now up to November 2012. If the federal government is to function during the rest of the fiscal year Congress needs to pass a budget resolution and raise the debt ceiling. That government will temporary grind to a halt is not unheard of – it happened twice in the mid-1990s. Yet it would be a mistake to assume that the Republicans won’t think twice about switching off the lights in the government buildings in the belief that the people will automatically blame the party occupying the White House. In 1995, the Democrats were also in power yet voters largely held the Republicans responsible for the government shutdown.

The parties may remove the obstacles that could stop the federal government from operating in the short term. However, we doubt if they will tackle the essential issues. Lawmakers are shouting at the top of their voices that the US should pursue a sustainable fiscal policy but there are five extremely costly achievements of the (welfare) state that no politician would dare touch. We’re talking about the military, Medicare, Medicaid, rebates and other tax breaks plus, albeit to a lesser degree, Social Security. 

Perhaps the two parties will finally muster the courage to reform those spending areas and safeguard the sustainability of the US welfare state after the presidential elections. Yet if the Democrats and Republicans fail to strike a Grand Bargain the markets will be merciless. The US will end up in a vicious circle of mounting indebtedness, soaring interest rates, increasing interest payments, even more debt, and so on. Until the start of 2013 the markets may still show patience towards the US but once it turns out that no major progress is made after the 2012 elections, they will rise up in arms.

In the end, both politicians and the general public will need to recognize that the welfare state is not sustainable in its present form. Not least because the population is aging, while untenable promises have been made and money has been squandered in the past.

Most right-minded persons must agree that the western model of the democratic-capitalist welfare state is coming apart at the seams. However, it seems that nobody is prepared to make great sacrifices to imbue a slenderized version of the welfare state with new life and ensure that the perspectives of the younger generations are not all gloom and doom. If the markets spring to action, they will demand hard choices. By then it will no longer be possible to implement gradual reform that is spread evenly among people over a lengthy period of time. Discontent and uncertainty will prevail while populism could become even more entrenched. This will make it harder to effect the necessary changes.

This negative scenario is not a given. Americans could acknowledge that the course the US has set for itself will irrevocably lead to the abyss and beyond. Ironically, Europe could help the Americans become aware of this. Especially if other weak euro countries are forced to go cap in hand to the stronger EMU states. The eurozone is shaking to its foundations, Europe’s population will age sooner, and its national debts are a heavy burden. Some countries are already weighed down with almost unbearably high interest charges. Yes, one could learn a lot from the bad example that Europe is setting. If the Americans take heed, there may still be time to avert disaster.

ECR Research (www.ecrresearch.com) is one of Europe’s leading independent macroeconomic research institutes focusing on the main currency and interest rate markets. The ECR reports reach a worldwide audience of sophisticated investors and treasurers and CFO’s within corporations and financial institutions. ECR offers a wide range of research products which are online accessible and updated on a weekly basis.

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