Last minute debt deal is only a short term solution. For investors, the longer term implications of US government dysfunction are important, says Jeremy Lawson, Chief Economist of Standard Life Investments.
Despite the seemingly endless speculation regarding the potential consequences of a temporary US government default, Senate Democrats and Republicans once again did a last minute deal to raise the debt ceiling and end the government shutdown that began on October 1. The main terms of the agreement are that the government will reopen and be funded through to January 15, enforcement of the debt ceiling will be suspended until February 7, and a bipartisan panel will be set up to make recommendations by December 13 regarding entitlement and tax reform. Notably, the Republican leadership caved without extracting any significant concessions on Obamacare and so appear to have suffered a great deal of political damage for nothing.
Now that the immediate crisis is over, it is worthwhile assessing some of the consequences of this absurd political theatre. In the short term, the direct economic impact of the shutdown is likely to be fairly modest. Once furloughed government employees return to work, it will have been 12 business days since the shutdown began. Although this will have probably shaved between 0.3-0.5 percentage points off growth early in Q4, this should mostly be made up before the end of the quarter, particularly as returning government staff will receive back-pay for their absence.
The indirect impact is harder to gauge. We have not yet received any business surveys for October so we do not know whether firms will have responded to the increase in uncertainty by scaling back their hiring or investment plans. Although daily measures of consumer sentiment have fallen significantly, there has been a fairly weak relationship between sentiment and consumers’ spending in recent years and we won’t have any hard data on actual activity until October’s vehicle sales data are released at the beginning of November. Moreover, despite the deal, this period of uncertainty is by no means over. The continuing resolution and debt ceiling increase both last only until the beginning of the New Year, when another round of brinkmanship will begin.
This has important implications for Fed policy. When the FOMC decided not to taper in September, the statement observed that they were waiting for confirmation that the improvement in activity and the labour market would be sustained and that they were nervous about fiscal uncertainties. The shutdown, the commotion over the debt ceiling, and the fact that we could suffer a repeat dose in January and February, make it very unlikely that the Fed officials will feel sufficiently confident about the economic outlook to begin tapering before the end of the year. That means that tapering could now be pushed back as late as March 2014.
For investors, the longer term implications of US government dysfunction are arguably even more important. America’s constitution contains a myriad of checks and balances that enforce shared power among the three branches of government, helping to protect democracy, and basic human rights. In a sense it is a system that is designed to make policy changes difficult and prevent excessive government intrusion into the private sphere. This can of course be a positive attribute when there is little for government to do and economic growth is best served by the government getting out of the way of the private sector. But at the present time, when many of the risks to longer term fiscal sustainability and potential growth require concrete policy action, institutionalised stasis starts to look more like a burden.
A few examples illustrate this point well. Recent fiscal consolidation has been almost entirely focused on reducing discretionary defense and non-defense spending. But this type of spending has already fallen back to its 40-year average and is likely to fall well below that level over the coming decade. Meanwhile, entitlement spending, which is primarily responsible for the rising trend in government outlays, has been barely on the agenda at all and there is little common ground between the two parties on how to reform it. This matters because entitlement spending, which does little to contribute to long-term growth, is increasingly crowding out more growth-friendly areas of spending, such as education and public infrastructure. Increased ideological polarisation makes it harder to make progress on tax reform, energy policies, and the future of the government-sponsored enterprises like Fannie Mae and Freddie Mac. The longer reforms are delayed, the more likely that America’s potential growth will be harmed.
Another potential long term cost of dysfunction in Washington is that the US dollar could gradually lose its status as the world’s reserve currency. Reserve currency status confers a range of economic and financial benefits. It helps lower the cost of government borrowing, which in turn helps to hold down consumer and business borrowing costs as well. In addition, it makes it much easier for the US to fund its external deficit as historically, foreigners have been prepared to accept a lower return on their US investments than domestic investors have been able to obtain abroad. Consequently, America’s net foreign asset position is much healthier than decades of accumulated current account deficits would ordinarily have implied.
For now, the dollar’s reserve status is not really under threat because foreign central banks with large reserve holdings would suffer significant losses if they tried to dump their dollar holdings too quickly. In addition, the world’s other potential reserve currencies, such as the euro, have their own problems. Nevertheless, if Congress does not get its house in order over the coming years, we would expect global reserve diversification to accelerate.
17 October 2013
Jeremy Lawson, Chief Economist, Standard Life Investments