An Albatross Around the Fragile Recovery
With the nation’s credibility in international bond markets propped upon the razor’s edge, reports emerged from Washington over the weekend detailing a budget compromise between the Obama administration and Republican Party leaders. At the time of the writing of this column, it now appears that a last-minute accord will be brokered and passed into law to increase the federal debt limit, ensuring that America’s creditors will be paid.
While an interim agreement on the budget and debt limit stave off the immediate crisis–in large part by postponing efforts to tackle entitlement spending–the handling of the issue raises legitimate questions about the efficacy of the legislative process and legislators’ readiness to balance dogmatism with rational compromise. That Washington has redoubled as a source of broader market uncertainty rather than a normalizing influence is deeply inauspicious at this juncture in the recovery.
The most current data show listless private investment and consumption, a condition that is likely exacerbated by political standoff on issues of far-reaching economic significance.
A Ratings Downgrade?
The last few weeks’ brinkmanship has solidified that default on our obligations, however unlikely, may result from political circumstances if not fiscal ones. With this in mind, a downgrade of the country’s AAA credit rating is likely inevitable. A read of five-year credit default swaps suggests that, in the estimation of investors, a downward revision has already taken place. As of last week, the cost of insuring against a default was higher for Treasuries than for the sovereign bonds of at least eight other countries, including the Nordic nations, Canada, Germany and Australia.
Since the sovereign ratings process is somewhat opaque and cannot be reverse-engineered in full, it is not possible to say exactly when a formal adjustment will occur. For the ratings agencies, that calculation will be handled carefully, and not exclusively in a quantitative vacuum.
What does a downgrade mean for the United States? Inasmuch as it will convey little or no new information about the creditworthiness of the Treasury–it will be a reactive rather than forward-looking evaluation of credit quality–the direct market response should be muted. There may be a strong technical response, however, as some funds are forced to rebalance away from Treasuries given the lower rating.
Depending on the magnitude of that adjustment, the upward pressure on Treasury yields would increase; debt yields in the remaining AAA-rated countries would almost certainly fall. Overall, the potential for disruption would push capital to safe havens, which might have the perverse effect of pushing Treasury yields lower as well.
Bad Time for Playing Politics
In considering how the federal government can support a more robust recovery, I have long been of the view that it should take steps to build private-sector confidence. In fact, by fomenting conditions favorable to private-sector investment and hiring, the government might achieve more than it can through a standard Keynesian approach (see my column from the week of July 18).
Regrettably, the dialogue around the debt debate and the 11th hour solution have achieved the opposite, undermining investors and consumers’ collective sense that the parties will work to ensure normalcy and predictability.
The drags that evolving policy uncertainties are introducing to the economic equation are ill-timed, coinciding with new data that underlines the fragile state of the recovery. The Bureau of Economic Analysis (BEA) on Friday released its advance estimate of 2Q 2011 GDP growth. Qualified by its reliance on incomplete information, this initial take on the economy’s performance nonetheless paints a dim picture. Real GDP increased at a disappointing annual rate of 1.3 percent during the second quarter, marking the second-slowest pace of growth since the end of the recession. GDP growth in the first quarter was just 0.4 percent, due in large part to government cutbacks.
Absent entitlement reform, the budget compromise is more cosmetic than substantive. Given the current balance of power in Washington, the core issues will remain unresolved until a spirit of cooperation takes hold or until voters rebuke one group or the other.
Either way, some attention to the damaging effects of political dysfunction is in order. The country’s full growth potential will not be realized while our feet are firmly planted in the Rubicon.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.