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Archive for the ‘US economy’ Category

We who analyze political risk across countries usually look first at big events: terrorism, civil and international war, political repression, uprising, etc. On this, the two extremes of the spectrum are very easy to identify. The stable democracies score high, like the United States or Sweden or Botswana. The other side, such as DR Congo, Somalia, or Pakistan, scores low.

But how do you look into political risk within those relatively stable countries where there is no overt conflict?

You need to get deeper into regulatory risk (the risk that regulations will change), the nitty-gritty of politics (the risk that political disagreements will affect predictable and stable economic environment), regional risk (the risk of political change within certain regions), and wildcard situations (rare but highly consequential events).

In the United States, these factors are showing some movement, as election politics confronts budget politics.

From households to the federal government, the US consistently overspends its budget. The Republicans take the contradictory fiscal position of keeping taxes low but spending gargantuan amounts on overseas wars. Democrats stay reluctant to envision cuts in entitlements and general pork.

As the 2012 election season gathers steam, Republicans and Democrats are sticking to their grounds. Republicans, empowered by the Tea Party spirit, want steep spending cuts without raising taxes. Democrats want higher taxes along with some cuts.

Meanwhile American public debt grows by $40,000 a second.

Many Americans who chant “we are #1” live in a state of denial. As one writer put it, they “think of themselves as rugged individualists in no need of state help, but they take the money anyway in health care and pensions and all the other areas of American life where the federal government spends its cash.”

Unable to find a solution, Congress just keeps on raising that ceiling. In the last ten years, Congress has raised the US debt limit ten times. The public debt has just surpassed the previous limit of 14.29 trillion, and is in dire need of a higher ceiling.

In short, the most powerful country in the world regularly uses extraordinary measures to keep the government functioning.

Both US federal governments and state governments have shut down before. This politics of debt poses an unpredictable financial risk to thousands of large and small companies that do business with the government in almost all sectors imaginable, from healthcare to finance to defense to education to housing and more.

The wildcard situation is a default on US debt obligations. Moodys, the credit rating agency, says the risk of default is low, but not “de minimis.” Expect interest rates to rise anyway.

The short of this story is that the underlying problem is not as economic as it is political. The wrangle among US lawmakers on how to tackle debt raises the risk of regulatory changes as well. And that injects uncertainty into investment decisions: whether one is thinking of buying a home, or deciding to “privatize” one’s retirement pot, or considering setting up a large factory.

The deadline is August 2. I think there’s a 99 percent likelihood that a compromise will be reached, but probably just at the nick of time. Let’s see what happens.

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In the last post, I wrote primarily about political risks from the allocation of money: the government’s budget on the one hand, and individual income on the other. I argued that political risk in the medium term (5-10 years) will depend on how these two factors combine. In addition, there is one certainty that will raise the risk profile no matter which scenario materializes. This is what today’s post is about: the certainty of America’s population profile.

One type of demographic certainty is rooted in what’s known as the demographic transition theory: As societies become richer, the death rate of its population falls fast, followed much later by a fall in birth rates. Emerging markets experience a surge in people of productive age, which helps them grow real fast when combined with capital accumulation. The mature markets, with falling birth rates, lose their dynamism as the population becomes grayer.

All advanced industrial countries now confront political risks from demographic stagnation. One aspect of this involves resource transfer. Young people need to be taxed more to support rising numbers of the elderly. The elderly tries to keep this support intact by coming out to vote in large numbers during elections. In the US, every general election between 1972 and 2008 elicited greater turnout (%) from the older segments of the population than the younger segments. In the 2008 election, in which youth participation was the highest, 56% of citizens in the 18-44 years age range voted. 66% of citizens in the 45 and above age range voted. The total citizen population in the second category, by the way, exceeds that of the first category. (Calculated from US Census Bureau data.) 

Generational tussle over transfer of resources, therefore, is a certainty. (A side point: the young has tended to vote more for Democrats, and the old for Republicans.

The second aspect of the demographic certainty concerns immigration. In order to remain economically productive, the richer countries have no recourse in the medium term other than importing people from labor-surplus countries. Even though immigrant workers expand the tax base, and therefore the welfare resources available for the older generation, the greater cultural conservatism of the older generation views immigration with hostility. The older generation has voting power. Younger immigrants usually have no voting rights.

Look at Arizona, for example. 83% of the elderly in Arizona are white, and 42% of people under 25 are Hispanic. If they become citizens–a giant “if” for many of them–will they tolerate yielding a good chunk of their income to pay for the hostile elderly? Conversely, as the Economist wonders, will the old want to surrender some of their earnings to pay for public education and state universities where most of the immigrants go? While the outcome of these questions is uncertain, what is certain is that immigration politics will become nasty in an increasing number of states. Arizona, in my opinion, is the tip of the iceberg.

Demographic trends have shifted economic and political power among the states as well. As the Economist notes, “Of the 20 oldest states in 2009, 14 were in the north-east and Midwest. The sunbelt, in contrast, was home to eight of the ten states with the highest concentration of youth.”  The northeast will have fewer congressional seats and less say in presidential elections. Will the sunbelt continue to tolerate federal resource transfers to support the growing elderly in the north? The north will have to keep immigration-friendly policies to ensure an adequate economic base.

The south and the west will experience rapid population growth. The typically more conservative south will experience greater political clashes rooted in both generational and cultural gaps. So these regions will be economically more vibrant but also politically more volatile. The result will be polarization rooted in demography. Let me quote again from the Economist’s article, “One nation, divisible”:

All these conflicting interests are helping to polarise further America’s politics. In the 1976 election … 26% of voters lived in counties where one party won by 20 points or more. In 2008 a whopping 48% of voters did so. Strikingly, less than 400 of America’s 3,141 counties switched parties at the 2008 election. Politicians, like marketers, have become adept at identifying likely customers. “Bringing out the base” is the key to winning. As a result of this polarisation, satisfying a range of constituents is becoming harder. The federal stimulus revealed this well. The bail-out gratified some Wall Street bankers. Aid to state governments mostly helped workers in capital cities. But voters in places with battered housing markets got little benefit from either. James Gimpel, a political scientist at the University of Maryland, notes that areas with high rates of foreclosure, such as suburban Atlanta, were hotbeds of tea-party activism.

To me, greater political conflict, in localities around the US, between an influx of young immigrants and a larger proportion of graying population is a certainty in the medium term. During the national voting season every two years, what will transform the myriad local conflicts into election results is the voting pattern of younger citizens. They have tended to lean slightly closer to their immigrant friends than to their parents and grandparents. Will they continue to do so?

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If you are looking at political risk in America ten years down the road, what variables would concern you the most? I’d propose a combination of fiscal and poverty uncertainties, and an underlying demographic certainty. This post is about the two uncertainties; I’ll talk about demographics in the next one.

Fiscal uncertainty

The most recent fiscal years recorded the two highest budget deficits in the US since World War II. The Congressional Budget Office (CBO) estimates that on current trends the federal debt will rise from 62% to 87% of GDP by 2020, and all government debt (federal + state + local) will be 110% [1]. This, according to IMF, is among the worst fiscal trends in the advanced industrial countries.

The uncertainty is about what will end up being done to reduce debt. Though America has been able to borrow easily from abroad, that faucet is getting tighter. President Obama’s Simpson-Bowles commission is coming up with proposals, targeting entitlements (social security, Medicare, etc.), which make up 60% of government spending. Retirement age will be increased, Medicare benefits will decrease, along with a host of other initiatives.

The proposal to reduce government debt prioritizes spending cuts over tax increase. Congress just decided to extend Bush-era tax cuts, which adds to the fiscal uncertainty no matter how one looks at it. 70 percent of the debt reduction is to be achieved through spending cuts. But my forecast is that cuts in spending will largely bypasses defense and security, the largest component of discretionary spending [2]. Although the Simpson-Bowles plan calls defense cuts, including closing one-third of overseas bases, Republicans want to prioritize non-defense discretionary spending, which, according to The Economist, “would entail savage cuts to federal services without cutting the deficit much” [3].

Income uncertainty

Now here’s the wider context in which the “savage cuts” are planned. According to the 2010 census results, median American households have become poorer over the last decade. Between 1999 and 2009, national real median household income has fallen from $54,058 to $50,221. It has decreased in every state except five in which income is derived largely from natural resources, such as Alaska and Wyoming. In places like Michigan, median income has fallen by a drastic 21 percent [4].

As of November 2010, unemployment rate was 9.8%, quite high [5]. Many argue that the effects of the stimulus package are wearing off, which was behind the Fed’s decision two weeks ago to inject another $600 billion into the system. But the proportion of the employed population that has taken limits on pay, such as furloughs, pay cuts, etc., is the highest it has ever been. The latest addition is President Obama’s 2-year pay freeze for federal government workers. This freeze, by the way, excludes defense.

In the next ten years, will real household income recover significantly from this trough? That part is uncertain. In New York City, income has bounced back. In Q1, 2010, average weekly wages there have increased almost twelve times the national rate [6]. The main reason is that the government’s bail out nicely got Wall Street out of the mess it had created in the first place. But Main Street languishes.

A scenario grid

If we put these two axes together, as shown below, we have a crude 4-scenario matrix. Obviously, this is ideal-type—but it helps us visualize political risks.

A Rough Scenario Grid, 2020

The X-axis is about the fiscal uncertainty, specifically, the proportion of non-defense-related budget cuts in overall government austerity measures. The higher the proportion (shown on the right hand side), the greater the negative impact on welfare programs. The left quadrants depict the opposite: greater share of defense and security-related spending in overall budget cuts. The balance is uncertain because it will depend on Republican vs Democratic tussles in the coming years. Nonetheless, both welfare and security-related cuts will directly affect a large portion of the population. As economists Sam Bowles and Arjun Jayadev estimate, in post-9/11 America, 1 in 4 Americans in the labor force are direct or indirect parts of the security industry [7].

The Y-axis is about poverty, specifically the extent to which median households are able to recover from their downward trend in income. The bottom quadrants depict continuity of stagnation or an actual decrease in real income. The top quadrants depict a rosier picture, where the economic stimuli have worked, private sector begins to grow and employ more people, the government as a consequence gets greater income, and in general, all is well economically.

The top left quadrant, “Liberal Peace” is a situation in which real incomes have risen again. Because of higher tax receipts and political decisions, the social safety net has remained largely intact. However, cuts in defense have forced America to become somewhat isolationist, especially compared to the interventionist foreign policies of the 1990s and 2000s. In international relations, US has adopted the approach of “Live and Let Live.”

The bottom right quadrant is “Confrontation.” Median income has stagnated, but social services have been scaled back significantly. A greater proportion of people are floating, and desperate. In addition, large spending on defense and security continues, and America is continually embroiled in foreign interventions. The domestic security industry is also booming. In my mind, this is the politically riskiest combination.

So, which one, roughly speaking, are we heading toward? What other big variables might come into play? And what happens if the any of the other quadrants materializes?

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Note: [2] Discretionary spending is spending that is not statutory, i.e., it needs to be proposed and approved every year. The other references are linked directly to the sources online.

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President Obama’s budget projects 1.3 trillion dollars in deficit in fiscal 2011. This has provoked a Republican outrage that I simply fail to understand. Here are the facts:

  • When President Bush came to power, America was in its 3rd consecutive year of budget surplus.
  • He cut taxes and went on a spending binge, with strong Republican support. He eventually spent more than any other president since LBJ, including nearly a trillion on the invasion of Iraq.
  • In the process, the Republicans used up the surplus so swiftly that America ran a large deficit 7 out of the 8 Bush years, consecutively since 2001.
  • They accelerated the hands-off policies started during the Clinton era, giving financiers the biggest say in a democracy, and ushering the biggest downturn since the Great Depression.
  • The administration spent another $868 billion on bailing out the financiers and providing stimuli before bowing out in 2008.

So after the “frat boy shipped out,” as The Economist put it, leaving America in a mess on multiple fronts, his supporters are now upset that the “socialist” Obama administration has to run another budget deficit?

This is the type of irresponsible amnesia on part of the Republicans and the Tea Party fanatics that’s going to hurt America’s global position.

And that’s what my article is about.  But I had to introduce the context, because another irresponsible refrain you hear from the right is that the rest of the world is just out to get America.

My question is, will the world continue to sponsor the debt that the United States has raked up? America’s “aura of invincibility,” wrote David Sanger in the New York Times, will last “maybe a long, long time.” While investors would malign any other economy under similar management, it shrugs off “American financial exceptionalism.” So the capital markets worried this week about Europe’s growing debt, but they hardly paid attention to Moody’s polite warning that America’s financial health “will at some point put pressure on [America’s] triple-A government bond rating.”

This optimism and this belief in exceptionalism is a dangerous consequence of the way US politicians allowed the development of a neo-laissez faire: Just borrow and spend, all will be fine in the end. You see that in consumer habits, in subprime markets, in Wall Street’s philosophy of heavy leverage, and in wanton federal spending while lowering taxes. Risk management was mostly rhetoric.

And so, the US government debt burden now is 85 percent of GDP. This is higher than the proportion in the “socialistic” Europe vilified by the American right. Germany: 79 percent, France: 77 percent, Portugal: 76 percent, Britain: 69 percent, and Ireland, which IMF claimed was the sickest of them all: 61 percent.

Still ok, if someone (read: China) is willing to underwrite the debt. China still holds the world’s highest share of US treasury bonds, almost $800 billion worth. But it has been buying less and less, signaling discomfort.

In the 1990s, Canada lost Moody’s triple A rating when its combined federal and provincial debt approached 100% of GDP. As the US inches to that level, a ratings blow may be nearer than most optimists believe.

And for America, that type of a blow will be more than economic. It will send a powerful political message about the overstretch of the world’s superpower. The world wants to believe that US politicians will be able to enact meaningful fiscal change, keeping its long term financial health squarely in sight. But so far, especially with the naysaying, amnesiac, and reactionary performance shown by the right, they will have little to find comforting.

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