The US adopts Britain’s economic strategy
January 6, 2013 4:14 pm
by Gavyn Davies
Global equities rose by about 4 per cent last week as the markets breathed a massive sigh of relief about US fiscal policy. Yet merely avoiding the worst of the fiscal cliff is not enough to ensure a satisfactory outcome for the American economy. The fiscal and monetary strategy which has now emerged in the US bears a very close resemblance to the strategy which has been in place in the UK for the past three years. In the case of Britain, the combination of fiscal tightening along with aggressive quantitative easing by the central bank has so far led to economic stagnation.
At first blush, recent events in the UK therefore do not inspire much confidence that the US is now headed in the right direction. But the two economies are not identical, and there are solid grounds for expecting the US to perform better under its newly adopted economic approach than the UK has done. In particular, the US private sector seems to be in much better shape to absorb the effects of fiscal tightening than the UK private sector was in 2010.
The agreement on the fiscal cliff fell a long way short of the coordinated restructuring of US fiscal policy which Ben Bernanke and many others have been recommending. Most observers agree that the US should significantly tighten fiscal policy in the long run, while supporting the economy in the short run, but there seems to be no way of securing such an outcome from two political parties which disagree profoundly about the right means of achieving this end result. Instead, we seem destined to get a series of piecemeal tax and spending changes which would constitute a coherent medium term fiscal plan only by accident.
The tax measures which emerged last week will tighten fiscal policy by about 1.2 per cent of GDP in 2013.
In addition, there will be a further tightening of about 0.6 per cent of GDP from public spending reductions resulting from the 2011 sequestration agreement, and from the expiration of the 2009 Obama stimulus package. The result will be a tightening in the fiscal stance of about 1.8 per cent of GDP, which will be front-end loaded into the first half of the calendar year. Furthermore, additional expenditure cuts could emerge from the negotiations on the debt ceiling in March, though these are not likely to be very large in 2013. (See Greg Ip for details.)
The upshot is a fiscal tightening in the US this year which is as large as any imposed in a single year by the UK coalition government, and larger than planned by any other major economy in 2013. The effect on GDP growth is not to be sneezed at, especially since fiscal multipliers seem to be unusually high at present (as IMF Chief Economist Olivier Blanchard once again argued here last week). How can the US escape a sharp slowdown in growth in such circumstances?
As in the case of the UK from 2010-12, the scale of quantitative easing by the central bank should be helpful. The minutes of the December FOMC meeting surprised the bond market last week, because they suggested that several members of the committee expected to end the present programme of asset purchases around the middle of 2013. It is disappointing that the Fed has confused the markets in this way, since the whole point of recent changes in its communications strategy have been to focus on the economic conditions required for monetary easing to end, rather than on particular dates in the calendar.
But this will probably prove to be a red herring. Ben Bernanke and his colleagues who are in firm control of the FOMC have clearly changed their policy reaction function (see here), and will not allow asset purchases to end until there has been a decisive improvement in the labour market.
The uncertainty about the Fed is not so much about its intentions, which remain very dovish, but about the effectiveness of further doses of QE in stimulating the economy. Recent experience in the UK suggests that this may not be powerful enough to offset the full scale of the impending fiscal tightening.
So what are the key differences between the US and the UK? One is the much greater exposure of the US export sector to the rapidly growing export markets of Latin America and other emerging economies, instead of the depressed eurozone, which dominates UK export markets.
Keynesian analyses of the causes of UK economic stagnation regularly seem to ignore this trade factor, while emphasising the role of fiscal policy in explaining weak growth in Britain. In fact, export markets and the fiscal tightening have both been critical in explaining UK underperformance (see here).
However, the real reason for being more confident about prospects for the US is that the private sector is now rapidly reducing the financial surplus it acquired during the crisis:
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The private sector financial balance represents the excess of private income over expenditure, or equivalently the difference between total savings and total investment. When the balance is positive, the private sector is paying down debt or acquiring financial assets, and vice versa. From 2009-11, the US private sector reduced its expenditure so sharply that it ran a financial surplus of about 6 per cent of GDP, but in the last six quarters, this surplus has fallen by 2.5 percentage points as household savings have been reduced, and fixed investment has recovered, notably in homebuilding.
The US private sector is still paying down debt, but is doing so less rapidly than it was a couple of years ago, and that has allowed the economy to expand. In the UK, we have also seen some reduction in the private surplus, but not by enough to offset the fiscal tightening and the weakness of export markets.
Prospects for a further trend reduction in the private sector financial surplus as confidence rebounds seem to be better in the US than in the UK, where the outlook for homebuilding is relatively poor, and the banking sector remains dysfunctional. Recent work by Jan Hatzius and Sven Jari Stehn at Goldman Sachs suggests that the US private surplus could diminish at an annual rate of 1.5-2 per cent of GDP over the next three years, which is much more than seems likely in the UK. If correct, this would greatly mitigate the damage to growth from the fiscal tightening.
Same strategy, different results? That is what the markets seem to be betting upon, and they may well be right.
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