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The Divided States of America - What Does Their Debt Deal Mean?

The Divided States of America - What Does Their Debt Deal Mean?

By Bob Kohut 06.08.2011

For months the world has held its collective breath and watched in bewilderment as the government of the United States crept towards the edge of an abyss once thought impossible – a default of the full faith and credit of the United States Government.

While the agreement just signed by the American president on 02 August, 2011 might appear to some as a signal for the world to exhale, that belief may be more than a little premature.

The once mighty United States of America is now so badly divided they have presented the world with a debt deal no one likes and few understand.

Although the US Treasury Department now has the authority to continue borrowing to meet its obligations, the point of the impasse and the subsequent negotiations was to come up with a plan to attack the unsustainable deficit in the United States.

In the opinion of some who should know, the debt deal does not come close to that goal.  Bill Gross, investment manager of the world’s largest bond fund at California based PIMCO, had this to say in a newsletter to investors:

•    "Nothing in the congressional compromise reached over the weekend makes a significant dent in our $1.5 trillion deficit.  Trillions of further spending cuts, and yes trillions of tax hikes, are necessary to stabilise our "official" debt/GDP rates.”

Stephen Roach of Yale University and American Investment Bank Morgan Stanley chimed in with the following:

•    "Make no mistake; we are not getting a major breakthrough in America's fiscal dilemma out of this deal. Talk about kicking the can down the road - this is probably the biggest can that's ever been kicked."

The deal is evidence of the need to get the country’s financial house in some semblance of order. How that will be done is yet to be determined.

What then is in this debt deal and what does it mean for world markets and economies?

The big picture calls for $917 billion in spending cuts stretched out over a ten-year period in exchange for raising the debt limit for Treasury borrowing by $900 billion, which is not enough to fund the US government through their national elections in 2012.

The plan has a second step to authorise the needed additional borrowing authority in exchange for an additional $1.5 trillion in cuts, also over 10 years.  

While there is some confusion over the exact nature and timing of the $917 billion in cuts in the first step of the plan, it is the second step about which the world should be very concerned.

The deal calls for the creation of a 12 member commission – 6 from each of America’s two major political parties – who will be expected to specify from where the $1.5 trillion in savings will come and present their findings by November of this year.  If they fail to agree, the plan has a “trigger” that would lead to automatic cuts of $1.2 trillion from the US defense department budget and Medicare, the country’s medical coverage for its senior citizens.

The immediate reaction to the debt deal was an uptick in markets worldwide which quickly disappeared in the face of more bad economic news.  Global growth is slowing and one concern many have about the debt deal is the impact these immediate spending cuts will have on economic growth in the United States.

While a viable effort to deal with the US debt should strengthen the US dollar in the short term, the benefit may be outweighed by slowing growth and continued concerns over US economic policy, or lack of it.  

Unfortunately, the debt deal pushed the “viable effort” into the hands of a commission that is likely to replicate the ugly process we have just witnessed.

The sad fact is what we witnessed this summer in the US we are likely to see again in the fall and through the winter and beyond.  What much of the world does not realize is how deep the divisions in the United States actually are.

Perhaps one day history will pass judgment that the United States began its gradual descent into becoming the Divided States during the Vietnam era.

A generation who had answered its country’s call to action in World War II watched in horror as their sons and daughters rebelled.  The seeds of the current impasse were laid with chants of “Hell no, we won’t go.”  In subsequent decades the seeds blossomed into bitter debates over the role of the federal government; debates that have become more heated over the years.

Once upon a time members of the Republican party and the Democratic party serving in the United States congress actually talked to each other and socialised after hours; but no more.  Both sides are dug in deep, backed by rabid and doctrinaire followers in their respective political base.  As you may have read, compromise to some in that country has become a dirty word.

Nowhere are these divisions more evident than in the debate over taxes and spending.  The GFC hit the US very hard, and Democrats support revenue and tax increases to go along with spending cuts as the only viable approach to dealing with the debt and deficit problem.

Republicans claim taxes are already too high.  If you deal with American business people you have undoubtedly heard the truthful claim the nominal corporate tax rate in the United States is the one of the highest in the world – 35%.  The effective tax rate is 27.7% in 2009, according to Price Waterhouse Cooper.  Australia’s effective rate is 27.1%.  Because of the current capital gains taxation policy in the United States, that country’s top income earners pay an effective tax rate of 18%.  The Republican counter is that 47% of the country pays no income taxes at all.  And on and on it goes.

Note that Bill Gross of Pimco is one of a chorus of experts that believe the US debt can only be brought under control with a combination of spending cuts and revenue or tax increases.  During the summer debt deal wrangling there were proposals on the table to actually lower corporate tax rates and some individual tax rates.  However, the proposed closing of tax loopholes would result in net tax increases for many.

How likely is it this commission will succeed when Democrats demand both revenue increases and spending cuts and Republicans want spending cuts only?  We can only hope for the best.

Global markets and economies already paid a price for America’s political intransigence.  China‘s news agency had this to say, using the symbols of the Republican and Democratic parties:

•    The ugliest part of the saga is that the well-being of many other countries is also in the impact zone when the donkey and the elephant fight.

Right now the Asia-Pacific region is experiencing booming growth.  One of the world’s largest banks, HSBC, recently announced it will layoff 30,000 workers and close branch operations in the United States in anticipation of a major expansion into Asian markets beginning in 2013.

Can Asia continue faced with slowing growth coupled with debt and deficit concerns in the United States and Europe?  

The global Purchasing Managers Index for China declined slightly in July.  On 02 August the American stock market dropped 2% on the news consumer spending in July declined for the first time in two years.  This news followed a dismal manufacturing activity report in the US released earlier in the week and previously announced layoffs do not bode well for the upcoming report on employment in the United States.

Who will be there to buy products manufactured in Asia if the United States slips back into recession?  

While economic power will inevitably continue its drift to the east, the United States economy is still the key to global growth.  Perhaps they have learned something from the debt deal debates.  Both the politicians and the population of that country would do well to remember the words of one of their greatest presidents, Abraham Lincoln:

A house divided against itself cannot stand.

>>Back to the newsletter to view other articles - August 6th 2011


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