A solution to the debt-ceiling crisis could unleash business investment in the United States, but will require tough decisions on tax and entitlement. George Mitton reports.
You are the chief executive of an American manufacturer. Your team comes to you with a plan for a new factory. The prospects are good, they say. Even under pessimistic projections, the factory should be profitable within a few years.
After all, there are many supporting factors for American manufacturers: energy prices have fallen and wage inflation in emerging markets has made the US more competitive.
You want to give the order to build, but you are worried about tail risks in the economy. You are not sure about the state of the banks. What if your funding for the project were to be switched off? What if creditors became risk-averse?
Prudence prevails. You put the plan on hold. You tell your colleagues you will review the plans for the factory in six months’ time.
Economists say this chain of events is happening all over the US, with limiting effects on growth. They say there is pent-up demand for business investment that has not been released because companies are uneasy about uncertainty. And this uncertainty centres on the political debate over the national debt.
“The United States is a bit like a car that’s revving, but the handbrake is on,” says Joshua McCallum, senior fixed income economist at UBS Global Asset Management. “That handbrake is our friends in Washington.”
THE DEBT CEILING
The US economy started the year with some good news. Politicians found a solution to the fiscal cliff, the combination of automatic tax rises and spending cuts which were due to come into effect on January 1. The stock market reacted well. By the end of January, the S&P 500 had increased more than 5% since the start of the year.
However, commentators were quick to observe that the last-minute deal was only a temporary solution. Politicians had negotiated a deal on taxes but had yet to tackle the larger problem of the debt ceiling, a government-imposed borrowing limit designed to force a resolution to runaway public spending. Some commentators were disparaging about what had been achieved.
“Policymakers have placed a small plaster on a gaping wound and are hoping growth will solve the problems,” says Mouhammed Choukeir, chief investment officer at Kleinwort Benson, a private bank.
There does not seem much hope of a speedy resolution. On January 23, Congress voted to suspend the debt ceiling until May. Though this buys more time for negotiations, it means uncertainty will continue to plague the economy for several months. That could mean more business investments postponed while the politicians play high-level brinkmanship over public spending.
And there is plenty still to do. As well as suspend the debt ceiling, the newly passed legislation called for politicians to pass their first budget in almost four years by April 15, or have their pay withheld.
McCallum sees the negotiation as a game of poker. In the first hand, the fiscal cliff deal, the Democrats scored a victory. The Republicans were forced to compromise on tax and allow a number of tax rises for wealthier people. But in the coming debates, the Republicans have a stronger hand. The Democrats want to defend public spending. If an agreement is not reached, and the US government shuts down, the Democrats are likely to be blamed for failing to compromise.
The longer the game of poker goes on, however, the longer the US economy will be hamstrung.
“Uncertainty is debilitating,” he says. “What we need is something that provides some business certainty. The risk is the politicians kick things down and do microdeals rather than any grand bargain. To me, that is going to hobble the potential recovery.”
If the government were to adopt a fairly moderate, middle-way approach, McCallum’s forecast for 2013 is pretty good. If there was gradual fiscal tightening of between 1% and 1.5% a year and a deal that provided clarity on tax rates for the next few years so that households and businesses can start to plan, he believes GDP could grow more than 3%.
But it is not certain that politicians will agree on this, and it will take a few months to find out if they do.
It is also unclear whether the debt-ceiling negotiations will find solutions to the long-term, structural imbalances in the US budget.
The structural challenges the US faces are the same as for most developed countries: how to pay for the cost of social security, and how to meet the increasing demands of an ageing population.
Higher taxes is one solution, though this is opposed by the Republicans. Another option is to raise the retirement age by one or two years, or to means-test the benefits that pensioners qualify for.
These are large and politically loaded questions. However, some believe a solution will be found that puts the US on a long-term trajectory to growth.
“Small changes today have big impacts,” says Grant Bowers, portfolio manager at Franklin Templeton. “These are solveable issues if you get compromise and, I think, we will.
“We’ve always believed that cooler heads will prevail,” he adds. “Politicians will posture. They will wait until the last moment to make a deal, but in the end there will be a compromise.”
If, and when, such a deal is reached, and the handbrake is released, there are many reasons to think US growth will be impressive.
Not only is there pent-up demand for business investment, but the household sector has made significant progress in paying down debts, which could lead to a rise in consumer spending, which has historically driven the US economy.
There are signs the housing market is continuing its recovery from the subprime mortgage crash with new home sales up on last year and house prices continuing to rise. The S&P/Case-Shiller home price index rose 5.5% in the 12 months to November, its fastest rate since 2006.
“Housing has a tremendous multiplier on the economy,” says Bowers.
Then there is a series of trends that are creating what some have called a manufacturing renaissance in the US. The exploitation of shale drilling, which blasts through rock formations to unlock gas that was previously inaccessible to energy companies, has helped produce a huge glut of supply that has pushed down prices to their lowest cost in a decade.
Any manufacturer that buys natural gas as a feedstock – makers of steel, aluminium, paper or chemicals, for instance – has been granted a big discount. As more manufacturers set up factories in the US to benefit from these low prices, other companies in their supply chain, such as automation, transport, truck and rail companies, will benefit too.
Then there are rising labour costs in emerging markets. China has had double-digit wage growth in recent years, and this seems set to continue.
“The labour cost advantage, adjusted for productivity, is disappearing,” says Bowers.
These increases are wiping out the savings US firms made when they outsourced manufacturing to the Far East, prompting many to consider bringing that capacity back home, or “onshoring” it.
For manufacturers that sell largely to US customers, onshoring also has the benefit of lowering the reliance on shipping, which with oil as high as $100 a barrel, can be a significant cost.
Finally, the US still has the advantages that it’s had for the last century. A large, qualified and flexible workforce that is willing to move to where the work is. The vast landmass of the US is united by one dominant language and a fairly uniform culture, very different to the struggling European Union, in which labour mobility between nations that are divided by language and cultural barriers has proved limited.
“People in the US will move,” says Bowers. “That’s one of the big differences between here and Europe. If I didn’t have a job here [in San Mateo, California] and there were jobs in Colorado, I would move to Colorado.
The unity of the US is a long-term advantage.”
The US has the fuel, the engineering and the expertise to accelerate to a rapid economic pace, but it needs its politicians to release the brakes.
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