05/24/2013 04:05 PM

Suicide by Sequester

US Feels Pinch of Erratic Spending Cuts

By Sebastian Fischer and Sandra Sperber in Washington

The pain of the sequester has been bearable thus far, but that will soon change. This summer, thousands of Americans will suffer due to cuts triggered by the entrenched budgetary battle in Washington -- and the damage could last for generations.

Despite being only 32, Alicia Tolliver has had no shortage of tough breaks in life -- a teen pregnancy, dropping out of school, unemployment and homelessness. Eventually, though, she found a resource in Head Start, an American health and human services program for young low-income children and their families. For Tolliver, Head Start served as a motivational program as well. She went back to school, completed a training course and found a job.

But then things went downhill again. With the financial crisis came unemployment and the loss of her apartment and car. Again, Tolliver found salvation through Head Start, as she fought to keep things together for herself and her three children.

But then came the sequester.

"It's frustrating," Tolliver says. Once again, she's about to watch everything fall apart.

A sequester is a compulsory budget cut, the kind of idea only politicians could come up with. With the country deeply in debt and President Barack Obama and the Republicans unable to agree on how to make long-term budgetary cuts, the two factions cobbled together a ticking time bomb of austerity, set to go off in 2013. The idea was that these cuts would be so absurd that one side or the other would have to back off and yield ground in order to prevent the bomb from going off.

That's what the president thought would happen. That's what the Republicans thought would happen. It didn't.

Cutting with Wanton Abandon

The grace period expired on March 1 with no agreement reached, and since then the government has been cutting programs at random, lawn-mower style -- $85 billion (€66 billion) in spending cuts have to be made by the end of September, an amount roughly equal to the entire federal budget of Austria. In other words, within the space of half a year, the US needs to slash the equivalent of Austria from its budget. Hundreds of thousands of jobs are at stake.

And if politicians in Washington still haven't reached an agreement by that point, the cuts will continue. The country is in danger of existing in a perpetual sequester, with another $1.2 trillion in budget reductions needed by 2021.

Since the effects of the first wave of cuts were hardly noticeable at first, many Americans have already almost forgotten about this bizarre construct called a "sequester." The TV broadcaster CBS recently conducted a survey asking Americans if they were affected by the sequester. More than two-thirds answered that they weren't. Now, though, as summer starts, the sequester is about to hit in earnest.

Secretary of Defense Chuck Hagel just announced 11 furlough days for around 650,000 civilian employees of his department. Federal law enforcement, disaster response teams, financial oversight, science and research -- all are experiencing cuts. Head Start, which is funded by the Department of Health and Human Services, will also be affected. Nationwide, about 70,000 of the approximately 1 million children currently enrolled in the program will no longer receive support from the program.

Those cuts will affect the Head Start Parent Child Center on 13th Street in Washington, where Alicia Tolliver takes her youngest daughter. Starting on July 1, 20 children will suddenly be left with "no nutritious meals, no benefits of seeing a doctor on-site, no dental services on-site," says Almeta Keys, the center's director. Keys has already been forced to consider which children she'll select to be removed from the program. Tolliver and her daughter, she says, will most likely have to go.

Keys considers the mandatory cuts absurd -- not only because they affect "the poorest of the poor," but also because cost-cutting today means more expenses tomorrow. "For every dollar Congress invests in Head Start," she says, "it's a $7 savings across the board on our local communities." Why? "Because fewer of these kids drop out of school, because their future health costs are lower, because we'll need fewer prisons."

Like Medieval Leeching

The absurdity of the cuts angers the people they affect. The US can undoubtedly see how Southern Europe is driving itself into the ground with its belt-tightening measures and how unemployment there is skyrocketing. But, here, the country is pulling its own plug. "Austerity, including sequestration, is the economic version of medieval leeching," wrote Jared Bernstein, former chief economic adviser to Vice President Joseph Biden, in the New York Times in early May. People in the Middle Ages believed a sick person needed to lose supposedly bad blood in order to regain health.

That, of course, was nonsense.

In fact, more than a few American economists advise investing rather than making cuts. Such investing could come in the form of the kinds of massive infrastructure projects that have traditionally been used to create jobs in times of economic slowdown. And, as can be seen by Thursday's collapse of a bridge on a highly trafficked interstate highway in Washington State, there's plenty of evidence that the US could use upgraded infrastructure. Looking at bridges alone, in its 2013 Report Card for America's Infrastructure, the American Society of Civil Engineers rated one out of nine of the country's over 600,000 bridges as "structurally deficient."

What's more, the federal deficit is already decreasing faster than expected. The independent statisticians at the Congressional Budget Office (CBO) expect new debt of $642 billion in 2013, around $200 billion less than had been predicted at the start of the year. And the International Monetary Fund (IMF) warns that the US shouldn't overdo it with budget cuts, with the country's unemployment rate still high, at 7.5 percent.

Alicia Tolliver recently organized a march of parents with strollers who converged on Congress in support of Head Start. There, Breeany, just five years old, read to members of Congress out of a children's book as an example of Head Start's accomplishments. It didn't help. Some of the program's centers have already had to close.

Other government programs, though, have fared better. For example, private donors have seen to it that the Yellowstone and Grand Teton national parks will be able to stay open all summer. And in other places, the lawn-mower method has been called off entirely. For example, Democrats and Republicans were suddenly very much in agreement on a decision to end air traffic controller furloughs. Lawmakers have given the Federal Aviation Administration more spending flexibility to cuts its budget, preventing long lines at airports.

"If we were the pilots who fly members of Congress home, maybe we wouldn't have had our funding cut either," says Keys, the Head Start center director.

Translated from the German by Ella Ornstein


While the world's economies jockey one another for the lead in the currency devaluation derby, it's worth considering the value of the prize they are seeking. They believe a weak currency opens the door to trade dominance, by allowing manufacturers to undercut foreign rivals, and to economic growth, by fighting deflation. On the other side of the coin, they believe a strong currency is an economic albatross that leads to stagnation. But the demonstrable effects of currency strength and weakness reveal the emptiness of their theory.

A country that attracts investment from abroad (through stable and fair governance, low taxes, a growing economy, and a productive labor force) and produces goods that are in demand on the global stage will generally see a rising currency. In essence, this is the reward for a job well done. Strong currencies then help nations stay strong by conferring greater purchasing power to its citizens and businesses, which keeps input costs low, thereby enhancing international competitiveness. Strong currencies also encourage savings, keep real interest rates low, lower capital costs, and allow for greater productivity and higher real wages.

It is often argued that a weak currency confers advantages in foreign trade. But the edge only results from putting exports on sale. Any merchant will tell you that it's easy to sell more if you cut prices, but most would prefer charging full retail. However, exports are not an end in themselves, they are a means to pay for imports. The goal of an economy is not to work, but to consume. If citizens in one nation buy goods produced in another, they must pay with exports. When a nation's currency appreciates imports cost less and fewer exports are needed to pay. This means goods and services at home will be cheaper and more plentiful, and citizens won't need to work as hard to buy them. This is the definition of rising living standards.

But when it comes to relative currency valuations, the United States dollar exists in a world of its own. As the international reserve, the dollar is the de-facto beneficiary of any other country's intervention. When countries intervene, they do so specifically against the dollar. In addition, many countries, (China and Taiwan for instance) maintain a pegged relationship to the Greenback.

Therefore in a world dominated by interventionist banks, the factors that push the dollar have been inverted. The dollar falls when fundamentals either improve abroad or deteriorate at home (both cases increase the propensity for intervention). The rest of the world's currencies compete on their own merit. As a result, it is not an accident that over the last decade Australia, New Zealand, and Switzerland, three of the world's strongest economies, have produced strong currencies.

Since 2001, all three have had generally appreciating currencies, accompanied by steadily rising exports, strong economic fundamentals, and low unemployment. From 2001 to 2012, the Kiwi Dollar appreciated by 98% against the U.S. dollar, but its exports in local currency terms increased by 40% (170% in U.S. dollar terms). Over the same time frame, the Aussie dollar appreciated by 103% and exports increased by 102% in local currency (and 305% in U.S. dollar terms). In Switzerland the story was the same, currency up 82%, exports up 53% in local terms and (and 175% in U.S. terms).

Where exactly did they encounter export troubles due to their rising currencies?

At the same time, the strengthening currencies made few negative impacts on other aspects of economic performance. At the time when the Swiss bankers caved to international pressure in September 2011 and pegged its previously surging franc to the euro, their economy had shown some of the best economic performance on the Continent. More recently, Australia and New Zealand reported stunning job creation figures. Adjusted for population, the U.S. would have had to create more than 600,000 jobs per month to keep pace with Australia, and 900,000 jobs per month to match New Zealand (U.S. job creation has averaged about 169,000 per month over the last year).

These lessons have been wholly lost on the Japanese who are frantically trying (and succeeding) in severely devaluing the yen. Although Japan's export machine had not suffered from the yen's appreciation from 2001-2012 (up 30% in local currency exports and 98% in dollar terms), newly installed prime minister Shinzo Abe and his minions at the Bank of Japan believe a weaker yen is the key to renewed economic strength. But the collapse of the yen has helped push up both the Aussie and Kiwi dollars, which has spurred bankers in Australia and New Zealand into taking unneeded and ultimately self-destructive actions. In April they threw in their lot with the interventionists and cut interest rates to stop the rise of their currencies. But the moves fly in the face of the modern playbook which states that policy should be tightened during periods of full employment, strong growth, and surging real estate prices. The misplaced fear of a strong currency seems to trump all other concerns.

While there is little reason to believe that strong currencies stifle exports, there is ample evidence that they increase domestic purchasing power (which is a real test of economic success). In the United States, oil currently sells for about $97 per barrel, about 16% below the $113 high price seen in April 2011. And so while our economy falters, at least consumers are not saddled with surging energy costs. While the 20% devaluation of the yen since that high in 2011 has made Japan the champion of Keynesian economists, it also means that oil in Japan is currently selling for the highest price since the financial crisis of 2008-2009. And it's not just oil, the Japanese must pay more for everything they import. How this benefits the rank and file has yet to be properly explained.

The latest data confirms that the banzai attack on the yen has not helped Japan's trade position. The weaker currency led to higher import costs, resulting in the 10th month in a row of trade deficits. Although April exports rose 3.8 percent from a year earlier, the trade deficit widened to 879.9 billion yen ($8.6 billion), the worst April since at least 1979. But the falling yen is creating a clear and present danger in Japan's enormous bond market. In less than one month, yields on 10 year Japanese Government Bonds have more than doubled, approaching nearly 1%. While those rates may sound manageable for most countries, Japan has the highest debt to GDP ratio in the developed world. If they had to pay 2% (the same rate as its inflation target), the country would need to devote more than half of its tax revenue just to service its debt! Clearly this possibility is dawning on stock investors who pushed down the Nikkei by more 7% today.

Never in the course of history has a country's economy failed because its currency was too strong. It's a pathology that simply does not exist. On the other hand, the list of those ruined by weak currencies is extensive. The view that a weak currency is desirable is so absurd that it could only have been devised to serve the political agenda of those engineering the descent. And while I don't blame policy makers from spinning self-serving fairy tales (that is their nature), I find extreme fault with those hypnotized members of the media and the financial establishment who have checked their reason at the door.

A currency war is different from any other kind of conventional war in that the object is to kill oneself. The nation that succeeds in inflicting the most damage on its own citizens wins the war. The only real way to win is not to play.

May 23, 2013 7:39 pm

Many investors may not be living in the real world

By Stephen King

A recovery in the global economy would appear to be hallucinatory, writes Stephen King

No one can be strong when China is weak. That, at least, appeared to be the message from the economic data this week. New data suggest lacklustre growth in Chinasparking nervous sell-offs in other countries. A one-day decline of over 7 per cent in the Nikkei stock market index might seem like an overreaction but, last year, China was Japan’s most important export destination, accounting for more than 18 per cent of its goods exports. China now accounts for one-quarter of South Korea’s exports. China is also the third-largest destination for US exports, after Mexico and Canada.

Stock market wobbles cannot be attributed to China alone. Ben Bernanke, Federal Reserve chairman, revealed that asset purchases associated with quantitative easing might be tapered earlier tan investors expected, providing another reason for stock markets to lurch down. Meanwhile, rising bond yields in Japan have led to a new sense of unease: financial bets are no longer all one way.

The relationship between China and the rest of the world has changed significantly in recent years. Before the onset of the global financial crisis, China’s growth was heavily export-led and primarily driven by productivity-driven gains in competitiveness. Adjusted for inflation, exports rose between 20 and 30 per cent a year. Since the crisis, export momentum has faded rapidly. In 2012, exports rose a mere 6 per cent, held back in part by trauma in the eurozone. One consequence has been a remarkable reduction in China’s current account surplus, dropping from over 10 per cent of its gross domestic product in 2007 to 2.6 per cent last year.

During this period, China has tried to limit the pace of its economic slowdown by boosting investment in infrastructure. There is a strong case for doing so. The average rail density per square kilometre in China’s 10 largest urban cities, for example, is just a quarter of the developed world’s typical urban areas, according to the OECD.

Yet the boost to infrastructure investment has not been without its costs. Credit growth has been excessive, capital has been allocated inefficiently and productivity increases have faded. While the reduction in China’s surplus can be regarded as a welcome contribution to the easing of global financial imbalances, it has coincided with a loss of domestic economic momentum that is weighing on growth well beyond China’s borders.

The Chinese economy is not about to collapse. Continued urbanisation should deliver productivity gains fast enough to allow it to continue outperforming other countries.

Unlike most developed nations, there is still some room for manoeuvre on fiscal policy. But a Chinese slowdown, alongside – at best – anaemic recoveries in the developed world is a headache for policy makers. The temptation to pursue policies of economic nationalism is on the increase.

Quantitative easing and other related policies operate primarily through two channels. The first is the so-called portfolio channel, whereby central bank purchases of government paper lead to lower long-term interest rates, encouraging investors to switch into higher-yielding but riskier assets. This is supposed to make it easier for companies to raise money, boosting investment; households should also enjoy bigger gains in wealth, thereby prompting faster consumer spending.

This channel has not worked as well as expected. Asset prices have surged but the results have been mediocre. A gap has opened between financial hope and economic reality. By limiting export prospects for producers elsewhere in the world, a slowdown in China only widens the disconnect. Removing monetary support threatens to close the gap in abrupt fashionnot because of a pick-up in activity but via a sudden correction in asset prices.

The second channel works through a falling exchange rate. Some argue that one country’s QE-related exchange rate decline will ultimately bring benefits for other countries. Faced with a loss of export earnings, those who have chosen to avoid QE will eventually be forced to follow suit, thereby triggering more in the way of domestic portfolio effects.

But if the domestic economic effects of QE are disappointing, the primary effect of exchange rate declines will be to boost exports. With lacklustre global growth, that will surely only lead to accusations of currency wars. This second channel is bound to be a source of tension in Asia in the months ahead thanks to Japan’s massive continuing monetary loosening.

At the beginning of the year, there were high hopes that the world economy would be dragged out of its torpor thanks to the copious use of monetary drugs, recovery in the US and strength in China. Monetary drugs, however, appear to have hallucinatory effects.

In the absence of a recovery in the developed world, China’s slowdown is just one more reason to question whether financial investors have remained in touch with economic reality.

The writer is HSBC’s chief economist and author of ‘When the Money Runs Out’

Copyright The Financial Times Limited 2013.