Against the backdrop of a tepid US recovery, Eurozone recession and stuttering growth across the emerging economy complex, investors are beginning to focus on how that 'status quo' outcome impacts the odds of success, which after all, if there is one thing economists agree on, it is that a US and global recession will ensue if the legislated tax increases and spending cuts worth roughly 3.5% of US GDP take effect next year. UBS believes that if the US economy dips into recession next year, operating earnings—which are near peak levels—could easily plunge by a fifth. Risk premiums would almost certainly climb, particularly because the US and the world would have run out of policies that could lift their economies out of recession. Those factors point to significant downside risk (at least 30%) for global equity markets if the US falls off the 'cliff'. Yet the S&P500 remains within a few percentage points of its cyclical highs. Accordingly, as we have previously concluded investors assign a very low probability to the ‘cliff’ and a 2013 US recession, which UBS finds 'darn surprising' that this much faith in common sense prevailing in Washington amidst such divisive politics.
Via UBS Investment Research
Quick fix or long-term solution?
...Curiously, investors appear to have a great deal of faith that... common sense will prevail in Washington and the ‘cliff’ will be averted. Consider that if the US economy dips into recession next year, operating earnings—which are near peak levels—could easily plunge by a fifth. Risk premiums would almost certainly climb, particularly because the US and the world would have run out of policies that could lift their economies out of recession. Those factors point to significant downside risk (at least 30%) for global equity markets if the US falls off the ‘cliff’. Yet the S&P500 remains within a few percentage points of its cyclical highs. Accordingly, we can only conclude that investors assign a very low probability to the ‘cliff’ and a 2013 US recession.
That’s darn surprising against the backdrop of divisive US politics in recent years, including the political brinksmanship during the debt-ceiling negotiations in the summer of 2011 that nearly resulted in a US default. So it is difficult to understand the confidence that investors have in the ability of US politicians to accomplish in the next few months what they haven’t been able to do in the past two years. Basing investment decisions on the idea that the unthinkable is impossible is a curious trait after the unthinkable things that have occurred in recent years.
But for all the attention the ‘cliff’ deserves, the fundamental challenge for the US (and many other countries) is to address fiscal stability as a long-term necessity, not a short-term fix. Yet if fixing the 'cliff' is going to be, well, a cliff-hanger, is there any hope Washington can restore to health the country’s long-term fiscal position?
The answer may be surprising. Getting it right in the long run is do-able and there is precedent. But it will take political resolve and good growth. Even more, it will take significant re-balancing in the US and world economies. And that’s where the grounds for skepticism are greatest. But let’s first review the historical precedent—the large US fiscal adjustment during the 1990s—and see what it tells us about the chances for the same in the decade ahead.
From 1992-2000 the US general government balance improved by 7.5 percentage points of GDP (Chart 1). As a consequence, relatively large US budget deficits declined and eventually became surpluses. And as a further consequence, over the decade of the 1990s the US gross government debt-to-GDP ratio fell from 61.2% in 1990 to 54.5% in 2000 (OECD basis).
Oh, and by the way, for virtually the entire decade the US was led by divided government, with plenty of hard-nosed partisan politics.
So, could it happen again?
The answer depends on the factors that permitted the US to consolidate its public finances in the 1990s. Briefly put, the salient features of the US fiscal adjustment in the 1990s included the following:
- Deficit reduction was accompanied by strong growth. That seemingly trivial fact is non-trivial. When growth is high, so too are tax revenues, while at the same time many government expenditures fall.
- The US economy was able to grow in the 1990s for several reasons. Among them were a supply-side impulse owing to productivity gains associated with investment in and the application of information technology. On the demand side the key development was that private sector borrowing and spending more than offset public sector de-leveraging. And, finally, domestic purchasing power was underpinned by a strong dollar as well as sharp declines in real energy prices, particularly in the latter half of the 1990s.
- Growth was also enhanced by falling interest rates, which helped lift private sector borrowing among both households and firms. Interest rates fell in part because of receding inflation expectations, but also because of lower government borrowing. Put differently, deficit reduction in the 1990s did not have particularly large negative multipliers. In contrast, in the current environment of negative real interest rates, deficit reduction does not spur much new investment. As a consequence, and as the IMF has recently emphasized, fiscal multipliers today are very large.
- Strong growth in the 1990s also made deficit reduction politically possible, even popular. But political support also stemmed from the fact that the burden of adjustment was shared between falling expenditures and rising tax revenues (as shares of GDP). While not perfectly ‘fair’, the result was accepted by both political parties and the broad electorate.
- Spending restraint in the 1990s had its foundation in simple rules: The Budget Enforcement Act of 1990 with caps on annual spending and ‘PAYGO’, which stipulated that Congress had to find offsetting expenditure reductions or tax increases for any budget measures that increased spending or cut taxes.
- Moreover, after the first Gulf War the US avoided costly foreign conflicts in the 1990s. Deficit reduction was also underpinned by the ‘peace dividend’ associated with the end of the Cold War. Defense spending as a share of GDP fell from 5.8% in 1988 to 3.0% in 2000.
- Falling (long-term) interest rates over the decade helped in another way - they reduced net interest expense for the US government from 3.6% of GDP in 1991 to 2.2% of GDP by 2001.
So, could it happen again?
Overall, the challenge today looks daunting. In at least four important respects, the experience of the 1990s is not particularly relevant to the present:
- The size of the US federal budget deficit today is much larger, as is the stock of debt. The mountain to climb is considerably higher.
- Interest rates are already low, probably can’t fall much further, and one day will rise. When that happens, interest expense on the stock of debt will rise, particularly since the US Treasury has not opted to aggressively lock in today’s super-low bond yields.
- Despite winding down two costly wars in the Middle East, the US remains uniquely burdened with its role as guarantor of global geopolitical stability. In 2011 the US spent 4.7% of GDP on national defense—above its two-decade low of 3.0% in 2000, but below the levels of the late 1980s. While some reduction in US military outlays may be possible, a large peace dividend in the decade ahead appears unlikely.
- US demographics—while not as scary as those in Japan, China, or large parts of Eastern and Western Europe—embed a rapid escalation of government expenditures for healthcare and pensions, particularly in the next two decades (before the US demographic profile again improves).
In short, faced with a big fiscal adjustment and without the ability to count on lower interest rates or big cuts in defense spending, the restoration of long-term US fiscal stability hinges on a combination of good public policy and good growth.
Neither can be assumed, but nor can either be categorically ruled out. As regards good public policy, a number of factors must come together to produce the right result, but as the 1990s experience suggests two ingredients are probably crucial:
- First, the burden of adjustment ought to be shared between falling expenditures and rising tax revenues, each as a percentage of GDP. ‘Fairness’ matters, even more so today given the large skew in US household income distribution and very uneven changes in living standards over recent decades. But the good news is that with the share of Federal government tax revenues as a share of GDP near post-war lows, scope exists to improve government revenue-generation.
- Second, simple rules work best. For example legislation that would stipulate that nominal government expenditures must grow fractionally slower than nominal GDP would work wonders if maintained for a decade or more. But as the 1990s also showed, strong growth is essential to long-term deficit reduction. Then, it was a two-part story of productivity and borrow-spend in the private sector.
Today, after nearly two decades of already high productivity growth, another productivity-led growth spurt seems improbable to many observers. Yet reasons for optimism exist. The US economy may be on the verge of revival, centered on energy, technology, and manufacturing, underpinned by a more competitive economy courtesy of a low real exchange rate. Faster US trend growth is not impossible to imagine.
But the big difference between growth in the 1990s and the prospects ahead resides in financial balances. Improving the fiscal imbalance will require an offsetting deterioration in the household or business sector balance, and/or a significant improvement in the external balance. If not, deficit reduction will sap aggregate demand, leading to below-trend growth (if not recession) and rising unemployment, an unsustainable state of affairs. Put differently, either US consumers or US businesses must borrow and spend more, or the US must generate a swing from net importer to net exporter, if deficit reduction is to be accompanied by the restoration and maintenance of full employment.
Yet re-balancing—domestically and globally—appears improbable in the years ahead. Significant re-leveraging of the US private sector is unlikely, not least because of a post-crisis regulatory environment inimical to debt. And hoping that the rest of the world, burdened by its own adjustments and blinkered by mercantilist thinking, will absorb US external surpluses seems even more farfetched.
So, the bottom line is that we’d better hope for a short-term fix to the ‘fiscal cliff’. At least that way we can avoid recession next year. That achievement, as difficult as it may be, looks comparatively easy next to the challenge of restoring long-term US fiscal probity.