The fiscal cliff deal

America’s European moment

The troubling similarities between the fiscal mismanagement in Washington and the mess in the euro zone

Jan 5th 2013

FOR the past three years America’s leaders have looked on Europe’s management of the euro crisis with barely disguised contempt. In the White House and on Capitol Hill there has been incredulity that Europe’s politicians could be so incompetent at handling an economic problem; so addicted to last-minute, short-term fixes; and so incapable of agreeing on a long-term strategy for the single currency.

Those criticisms were all valid, but now those who made them should take the planks from their own eyes. America’s economy may not be in as bad a state as Europe’s, but the failures of its politiciansepitomised by this week’s 11th-hour deal to avoid the calamity of the “fiscal cliff”—suggest that Washington’s pattern of dysfunction is disturbingly similar to the euro zone’s in three depressing ways.

Can-kicking is a transatlantic sport

The first is an inability to get beyond patching up. The euro crisis deepened because Europe’s politicians serially failed to solve the single currency’s structural weaknesses, resorting instead to a succession of temporary fixes, usually negotiated well after midnight.

America’s problems are different. Rather than facing an imminent debt crisis, as many European countries do, it needs to deal with the huge long-term gap between tax revenue and spending promises, particularly on health care, while not squeezing the economy too much in the short term. But its politicians now show themselves similarly addicted to kicking the can down the road at the last minute.

This week’s agreement, hammered out between Republican senators and the White House on New Year’s Eve, passed by the Senate in the early hours of New Year’s Day and by the House of Representatives later the same day, averted the spectre of recession. It eliminated most of the sweeping tax increases that were otherwise due to take effect from January 1st, except for those on the very wealthy, and temporarily put off all the threatened spending cuts.

Like many of Europe’s crisis summits, that staved off complete disaster: rather than squeezing 5% out of the economy (as the fiscal cliff implied) there will now be a more manageable fiscal squeeze of just over 1% of GDP in 2013. Markets rallied in relief.

But for how long? The automatic spending cuts have merely been postponed for two months, by which time Congress must also vote to increase the country’s debt ceiling if the Treasury is to be able to go on paying its bills. So more budgetary brinkmanship will be on display in the coming weeks.

And the temporary fix ignored America’s underlying fiscal problems. It did nothing to control the unsustainable path of “entitlementspending on pensions and health care (the latter is on track to double as a share of GDP over the next 25 years); nothing to rationalise America’s hideously complex and distorting tax code, which includes more than $1 trillion of deductions; and virtually nothing to close America’s big structural budget deficit. (Putting up tax rates at the very top simply does not raise much money.) Viewed through anything other than a two-month prism, it was an abject failure.
The final deal raised less tax revenue than John Boehner, the Republican speaker in the House of Representatives, once offered during the negotiations, and it included none of the entitlement reforms that President Barack Obama was once prepared to contemplate.

The reason behind this lamentable outcome is the outsize influence of narrow interest groups—which marks a second, unhappy parallel with Europe. The inability of Europeans to rise above petty national concerns, whether over who pays for bail-outs or who controls bank supervision, has prevented them from making the big compromises necessary to secure the single currency’s future. America’s Democrats and Republicans have proved similarly incapable of reaching a grand bargain; both are far too driven by their parties’ extremists and too focused on winning concessions from the other side to work steadily together to secure the country’s fiscal future.

The third parallel is that politicians have failed to be honest with voters. Just as Chancellor Angela Merkel and President François Hollande have avoided coming clean to the Germans and the French about what it will take to save the single currency, so neither Mr Obama nor the Republican leaders have been brave enough to tell Americans what it will really take to fix the fiscal mess. Democrats pretend that no changes are necessary to Medicare (health care for the elderly) or Social Security (pensions). Republican solutions always involve unspecified spending cuts, and they regard any tax rise as socialism. Each side prefers to denounce the other, reinforcing the very polarisation that is preventing progress.

Fixed today, hobbled tomorrow

Optimists will point out that America is unlikely to face a European-style debt crisis in the near future, but the slow-burning fuse is itself a problem. One positive side-effect of Europe’s crisis is that it has forced euro-zone countries to raise their retirement ages and rationalise pensions and health-care promises.

America, which has the biggest structural budget deficit in the rich world bar Japan, will become an outlier in its failure to deal with the fiscal consequences of an ageing population. Its ageing is slower than Europe’s but, as its debt piles up and business and consumer confidence is dampened, the eventual crunch will be more painful.

The saddest thing about this week’s deal is how unaware Messrs Obama and Boehner seem to be of the wider damage their petty partisanship is doing to their country. National security is not just about the number of tanks or rockets you have. As it has failed to deal with the single currency, Europe’s standing has crumbled in the world. Why should developing countries trust American leadership, when it seems incapable of solving anything at home? And while the West’s foremost democracy stays paralysed, China is making decisions and forging ahead.

This week Mr Obama boasted that he had fulfilled his mandate by raising taxes on the rich. In fact, by failing once again to clear up America’s fundamental fiscal trouble, he and Republican leaders are building Brussels on the Potomac.

The Political Economy of 2013

Mohamed A. El-Erian

03 January 2013


NEWPORT BEACHWatching America’s leaders scramble in the closing days of 2012 to avoid a “fiscal cliff” that would plunge the economy into recession was yet another illustration of an inconvenient truth: messy politics remains a major driver of economic developments.

In some cases during 2012, politics was a force for good: consider Prime Minister Mario Monti’s ability to pull Italy back from the brink of financial turmoil. But, in other cases, like Greece, political dysfunction aggravated economic problems.

Close and defining linkages between politics and economics are likely to persist in 2013. Having said this, we should also expect much greater segmentation in terms of impact – and that the consequences will affect both individual countries and the global system as a whole.

In some countries – for example, Italy, Japan, and the United States politics will remain the primary driver of economic-policy approaches. But elsewhere China, Egypt, Germany, and Greece come to mind – the reverse will be true, with economics becoming a key determinant of political outcomes.

This duality in causation speaks to a world that will become more heterogeneous in 2013 – and in at least two ways: it will lack unifying political themes, and it will be subject to multi-speed growth and financial dynamics that imply a range of possible scenarios for multilateral policy interactions.

With an election looming in Italy, the country’s technocratic interim administration will return the reins of power to a democratically elected government. The question, both for Italy and Europe as a whole, is whether the new government will maintain the current economic policy stance or shift to one that is less acceptable to the country’s external partners (particularly Germany and the European Central Bank).

Monti may or may not be involved in the new government. The further removed from it he is, the greater the temptation will be to alter the policy approach in response to popular pressures. This would involve less emphasis on fiscal and structural reforms, raising concerns in Berlin, Brussels, and Frankfurt.

Japan’s incoming government has already signaled an economic-policy pivot, relying on what it directly controls (fiscal policy), together with pressure on the Bank of Japan, to relax the monetary-policy stance, in an effort to generate faster growth and higher inflation. In the process, officials are weakening the yen. They will also try to lower Japan’s dependence on exports and rethink sending production facilities to lower-wage countries.

The economic impact of politics in the US, while important, will be less dynamic: absent a more cooperative Congress, politics will mute policy responses rather than fuel greater activism.
Continued congressional polarization would maintain policy uncertainty, confound debt and deficit negotiations, and impede economic growth. From stymieing medium-term fiscal reforms to delaying needed overhauls of the labor and housing markets, congressional dysfunction would keep US economic performance below its capacity; over time, it would also eat away at potential output.

In other countries, the causal direction will run primarily from economics to politics. In Egypt and Greece, for example, rising poverty, high unemployment, and financial turmoil could place governments under pressure. Popular frustration may not wait for the ballot box. Instead, hard times could fuel civil unrest, threatening their governments’ legitimacy, credibility, and effectiveness – and with no obvious alternatives that could ensure rapid economic recovery and rising living standards.

In China, the credibility of the incoming leadership will depend in large part on whether the economy can consolidate its soft landing. Specifically, any prolonged period of sub-7% growth could encourage opposition and dissent not only in the countryside, but also in urban centers.

Then there is Germany, which holds the key to the integrity and unity of the eurozone. So far, Chancellor Angela Merkel has been largely successful in insulating the German economy from the turmoil elsewhere in Europe.

Unemployment has remained remarkably low and confidence relatively high. And, while growth has moderated recently, Germany remains one of Europe’s best-performing economies – and not just its paymaster.

While some would have favored greater policy activism, Merkel’s Germany has provided a steady anchor for a eurozone struggling to end bouts of financial instability and put an end to questions about its survival as a well-functioning monetary union (one that aspires to becoming much more). A change in German leadership would, therefore, raise questions about Europe’s policy underpinning.

How politics and economics interact nationally and globally is one of the important questions for 2013 and beyond. There are three scenarios: good economics and effective politics provide the basis for a growing and more cooperative global economy; bad economics interact with dysfunctional politics to ruin the day; or the world muddles through, increasingly unstable, as a tug of war between economics and politics plays out, with no clear result or direction.

Part of the answer depends on what happens in three countries in particular – China, Germany, and the US. Their economic and political stability is essential to the well-being of a world economy that has yet to recover fully from the 2008 global financial crisis.

Current indications, albeit incomplete, suggest that the three will continue to anchor the global economy in 2013. That is the good news. The bad news is that their anchor may remain both tentative and insufficient to restore the level of growth and financial stability to which billions of people aspire.

Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment company PIMCO, with approximately $1.8 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, and 2011. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by the Economist.



Hope springs eternal

Investors are optimistic but 2013 is unlikely to be a bumper year

Jan 5th 2013

MARKETS are beginning the new year on an upbeat note. The immediate cause for celebration is the deal reached in America this week not to plunge over the fiscal cliff, although legislators have merely bought themselves another couple of months. More late-night negotiations will follow in February and March.

But even before the deal was struck, fund managers polled in December by Bank of America Merrill Lynch thought that the global economy would strengthen this year and that profits would rise. They were also more optimistic about the Chinese economy than they had ever been in previous surveys. (The latest Chinese purchasing managers’ indices were solid rather than spectacular.)

Canny investors will assume such optimism is already reflected in the price and will be looking out for surprises. At the start of last year few investors anticipated that shares in banks, or the government bonds of Greece and Portugal, would be among the best-performing assets of 2012.

When assessing the year ahead, most investment strategists start with the economic outlook. But that is often a mistake, as 2012 demonstrated. It was not a great year for growth in the developed world, nor indeed for profits, but stockmarkets still generated healthy returns.

The rally was largely the result of two factors. First, pessimism about the prospects of a euro-zone break-up was lifted by the willingness of the European Central Bank to buy the bonds of troubled nations. With his pledge to dowhatever it takes” to save the euro, Mario Draghi became the pin-up boy of the equity bulls.

Second, many equity markets started the year looking reasonably cheap, particularly in comparison with government bonds. Investors were attracted to corporate bonds and to shares with a decent dividend yield, since the income available from government bonds and cash had dwindled to historically low levels.

The consensus view is that investors will still be tempted to buy equities in 2013. Cash continues to provide a return of close to zero in most developed markets and there is no sign of an increase in interest rates. Government bonds in the “safemarkets of America and Germany offer dismal returns by historic standards.

A couple of caveats are needed, however. The first is the path followed by Japan after its bubble burst in the early 1990s. Government-bond yields fell to low levels and stayed there. Equities managed the occasional sharp rally and then slumped again; the Tokyo stockmarket is still trading at only a quarter of its end-1989 level. Perhaps the rest of the developed world is following the same script.

Furthermore, European and American investors may be tempted to hold on to their government bonds in the belief that central banks will not allow yields to rise significantly. Just as there was perceived to be a “Greenspan put” in the equity markets in the 1990s (ie, the Federal Reserve would always intervene if shares slumped), there may now be a “Bernanke put” in government bonds.

The second caveat is that the stockmarket gains in 2012 were largely driven by a revaluation of equities. “We know of no major asset class that is cheaper now than a year ago, and many are significantly more expensive,” says the strategy team at Morgan Stanley. On the most reliable measure, which averages profits over ten years, American shares trade on a cyclically adjusted price-earnings ratio of 21, well above the historic average, according to Robert Shiller of Yale University.

Profits may move higher this year. Analysts forecast an increase of 11% for the world as a whole. But analysts are always optimistic in January, only to revise down their expectations later in the year.

The greatest scope for profit increases may be in Europe, where margins are at a 20-year average. In American and Japan, in contrast, profits look high relative to GDP. Another bullish argument for European shares, made by strategists at Société Générale, is that they are trading at around their lowest valuation, relative to American equities, in the past 30 years.

Cautious optimism is probably the right attitude. Central banks may be keeping their feet to the monetary accelerator but the brakes are being applied in the form of fiscal policy. Even if the developed world is not stuck in a Japanese-style rut, a revival of global growth could bring renewed problems in the form of higher commodity prices. Although investors are not as complacent as they were heading into 2000 or 2007, say, it is still hard to believe this will be a bumper year for returns.

Updated January 4, 2013, 6:54 p.m. ET
Brazil Plans a Shift in Its Strategy

BRASILIA — Brazil is shifting gears in its effort revive its troubled economy, away from aggressive currency and interest-rate policies to a more hands-off approach, Finance Minister Guido Mantega said in an interview.

"In 2013 we will reap what we have sown," he said, predicting a return to strong growth after two years in the doldrums. "2013 will be calmer, with fewer measures, because they've been done."

Brazil, the world's second-largest developing economy after China, is a key bellwether for the economic health of the emerging world and a major source of growth, as Europe, the U.S. and Japan wrestle with debt woes.

During its slowdown, Brazil introduced a succession of measures, including a move to weaken its currency and one to cut what were once among the world's highest interest rates to a record low of 7.25%.

The change of pace comes as Mr. Mantega has attracted critics who say Brazil's rapid-fire policy packages are backfiring by spooking investors fearful of all the sudden rule changes. In an effort to reduce electricity prices, for example, Brazil is pressuring power companies to take less-profitable contracts.

In the interview, Mr. Mantega defended such policies as "good activism."

But overall, he expected 2013 to be a year of less policy making as the structural changes implemented in recent years take hold amid an improving global economy. Brazil's stock market will rise and the economy will grow between 3% and 4%, he said. "2013 will be a scenario of Bonanza."

There will be at least one exception: The government plans a measure to lower natural-gas prices to follow on its effort to cut electricity prices.

Growth in Brazil could signal a stronger recovery in China, Brazil's top trade partner, as well as profits for major U.S. and European companies that have expanded here in recent years.

Mr. Mantega and his boss, President Dilma Rousseff, have a lot riding on making that come true. Ms. Rousseff faces re-election in 2014 and has staked her political reputation on being able to turn the government's big role in the economy into fast economic growth. She has said publicly that she isn't considering replacing Mr. Mantega, but some analysts say she may be forced to do just that if the economy remains sluggish.

"She might make the decision in 2013, since she will be under pressure to prop up the economy if she wants to get re-elected," said David Fleischer, professor emeritus at the University of Brasilia.

Like other emerging-market nations, such as India, that swung to rapid growth rates in 2010, Brazil's economy recently has slowed. A China slowdown and a fall in global commodity prices hurt resource-rich Brazil, a leading global exporter of iron ore, soy and other materials.

Brazil's crumbling infrastructure, sprawling bureaucracy and serial corruption scandals has aggravated the problem. After hitting 7.5% growth in 2010, Brazil's expansion slowed to 2.7% in 2011 and to about 1% last year.

Mr. Mantega has predicted a Brazil recovery before—and has been wrong. He promised growth above 4% in both 2011 and 2012, earning criticism that his optimism was eroding his credibility. In his defense, Mr. Mantega said his once-seemingly optimistic predictions for Brazil's economy have turned out to be right in other years.

"I will remain an optimist because I know the potential of this economy," he says. "No one wants a depressed finance minister going around saying things won't work."

Mr. Mantega burst onto the global stage in 2010 by using Brazil's growing stature in international forums such as the Group of 20 to criticize decisions by the U.S. and Europe to set interest rates near zero. He argued that the measures amounted to a "currency war" that would give rich countries an unfair advantage over poor nations in global trade.

The phrase served to crystallize thinking about the spillover effects of monetary policy making in the industrialized world, and galvanized a grouping of emerging-market nations opposed to it. Analysts said the international cachet one reason Ms. Rousseff kept Mr. Mantega on as finance minister when she took office in January 2011, making him Brazil's second-longest-serving finance minister.

But as Brazil's economy has slowed over the years, some international economists have said Mr. Mantega has erred by placing too much blame for Brazil's woes on global economic trends instead of focusing on fixing Brazil's own economic bottlenecks.

"It becomes a red herring in terms of trying to shift the attention from much more difficult but essential structural reforms," said Cornell University professor Eswar Prasad, who has advised India and other emerging-market nations on currency and other economic issues.

Mr. Mantega says Brazil has proved skeptics wrong in the past. Conventional wisdom was that the country couldn't lower interest rates without sparking runaway inflation, but it did.

"We're certainly not orthodox conservatives," he said.

And his unorthodox policies are working, he said. Capital controls have weakened the currency by 25% since mid-2011, enough that manufacturers are starting to export more, he said. Brazil has maintained record low employment, by targeting tax breaks to industries, including automobile, to save jobs.


"Low unemployment isn't a miracle," he said.