Dueling Orthodoxies

World markets are counting down the 28 days to the end of the year - when, in America, a fiscal trigger of spending cuts and tax increases (amounting to a nearly 5% hit to GDP in a full year) is automatically pulled. Such an event would send a fragile recovery in the world's largest economy over a cliff - hardly what the world needs right now, as American unemployment remains high, as Europe slips back into recession, as Middle East turmoil rages, and the still export-led Latin American and Far Eastern economies continue to look to foreign demand to spur their domestic employment.

Two English words frame the seemingly implacable debate in Washington - rates and entitlements. "Rates" is the Republican orthodoxy - rates of personal income and other taxes must not rise - and "entitlements" is the Democratic orthodoxy - social security, medicare and medicaid programs must be protected. Without significant change in both, however, America's fiscal imbalance ($16 trillion of outstanding public debt, a level that now exceeds the total value of goods and services produced in America) will worsen, threatening world economic and political stability. It's nothing short of that.

Re-elected President Obama re-established an opening negotiating position to avert the cliff last week - rates must rise for the "wealthy", but not for the "middle class" - and Congress should cede to the President its right to set federal government annual borrowing limits. Two hours ago, House leader Boehner responded, with a 10-year proposal that would restrain entitlement expenditures (by increasing the eligibility age for Medicare and lowering the cost-of-living hikes for Social Security benefits), and raise $800 billion in tax revenues through tax code reforms, leaving the Bush-era tax cuts in place for now for all Americans.

Are these two positions really so far apart as to prevent a fiscal deal - or, at least, a credible down-payment - in Washington by year-end? Especially when the stakes, and the debt, are so high? This writer would suggest that if Washington were a corporate entity, answering to its Board and shareholders, a deal would have been done in the week immediately following the November Presidential election, failing which there would be executive firings. 

On The Road to Debt Write-Off

It took three additional meetings over the last three weeks, but EU Finance Ministers finally found a way late last night in Brussels to strike a new Greek deal.

As this writer suggested in "Europe Update", existing Greek debt is to be re-structured, so significantly (40 billion euro over 8 years) that, under the plan, the debt-to-GDP ratio is forecast to fall from as high as 190% in 2014 to 124% by the end of this decade. This is to be accomplished by cutting the interest rate on official loans by 100 basis points, extending their maturity by 15 years to 30 years, granting a 10-year interest repayment deferral, and giving back to Greece as much as 11 billion euros of the capital gains accruing to national central banks from European Central Bank repurchases of Greek government bonds in the secondary market. This latest deal will allow for the release next month, in stages, of the next tranche of 44 billion euros from the existing bail-out loan. Greece will thus be liquid again, for now.

One could be tempted to argue that such a debt re-structuring is so sweeping as to amount to a de facto debt forgiveness. But, technically, it is not - a point of crucial importance to Germany particularly. Chancellor Merkel, who faces a national election next September, needed to avoid the risk of alienating her bail-out-weary German electorate by agreeing to any write-off of Greek debt, yet at the same time mitigate the Greek debt burden to prevent an immediate collapse of that country's economy and the attendant impact across all of Europe. This re-structuring appears to do just enough to meet both criteria.

There is little doubt, however, that actual debt forgiveness will be required, likely sometime after the 2013 German election. Even if forecast assumptions turn out to be correct, Greek debt amounting to 124% of GDP by 2020, on however favorable terms, is simply not sustainable. Indeed, German Finance Minister Schaeuble said last night, "When Greece has achieved a primary budget surplus (the budget balance before debt interest payments) and fulfilled all of its conditions, we will, if need be, consider further measures for the reduction of the total debt".

Thus, many more chapters, on Greece and Europe, remain to be written.

Mr. Morsi et al.

History is replete with liberators becoming dictators - Simon Bolivar in 19th century Latin America, Gamal Nasser six decades ago in Egypt, Fidel Castro as the new year opened in 1959 in Cuba - to name a very few. And it appears that this tradition is unfolding once again in Egypt.

Egyptian President Morsi, narrowly elected last June as the Freedom and Justice Party's (read Muslim Brotherhood's) candidate in the presidential election, secured victory by promises of radical improvements in government services and, more sweepingly, by the immediate introduction of the al-Nahda, or "Renaissance Project", to finally lift the country onto a sustainable path of growth, development and social justice. It all seemed to fit perfectly with the aspirations of the Arab Spring, the broadly-based revolution in 2011 that toppled Hosni Mubarak, and six decades of military-backed Egyptian dictatorships.

Reality, however, has already jumped to the forefront. Economic growth is in free-fall, with tourism, exports, foreign-currency reserves, and private foreign investment inflows sinking. A $4.8 billion bail-out loan from the IMF appears imminent (there is preliminary agreement, pending final approval by the IMF Board in December), but will require severe austerity measures to bring the government budget deficit down, from its current level equivalent to nearly 11% of GDP, to the IMF's target of 8.5% by 2014. Even if this target is reached, deficits of this magnitude are hardly sustainable; restrained public spending together with higher taxation will be a feature for years to come.

And if such economic challenge is not enough, President Morsi, perhaps buoyed by his successful mediation this past week of a ceasefire between Israel and Gaza, decided to once again stir the always volatile Egyptian political pot. On November 22, he issued a seven-point decree granting himself sweeping new powers, including "temporary" executive power over the judiciary, asserting "the immunity of all presidential decrees from challenge by any other authority" until a new Constitution is introduced. Reaction has been instant, with mass protests in Cairo's Tahrir Square, and throughout the rest of the country and the world. There is word today that ensuing political instability could delay the IMF loan.

To conclude his "decree" address, Morsi stated that "the President may take the necessary actions and measures to protect the country and the goals of the revolution". Talk about historical tradition......

Not Enough to Just Tax, or Cut, or Grow

Here are four numbers that explain the urgency of fixing fiscal policy in America - 16, 43, 65, 106.

Some further explanation:

During the Great Depression (essentially, the decade of the 1930's), total government debt in the United States climbed from 16% of GDP (quick primer: this ratio is a common way of gauging the size of any given dollar amount of debt) to 43%. The dramatic increase reflected President Roosevelt's aggressive New Deal - the expansion of the federal government's involvement in the economy, as social safety nets and government projects were put in place to combat widespread unemployment. Fast forward to the beginning of the most recent financial near-collapse in 2007-08 and public debt was already at 65% of GDP. It has subsequently jumped to its current level equivalent to an estimated 106%. As in the 1930's, President Obama decided in 2008 to intervene massively; his administration has run four straight years of trillion dollar-plus deficits, despite the total debt-to-GDP ratio of 65% he inherited from the Bush administration.

So, with debt at levels never experienced except during World War II, there are now two urgent fiscal short-term issues, and a third, associated issue for the longer term. The first is that America is about to repeat last summer's debt-ceiling debacle. Congress and the White House will once again have to agree to raise the current ceiling of $16.39 trillion, by early next year (debt exceeded $16 trillion on August 31, 2012). Last year's negotiations were so politically difficult, and ultimately so inadequate, that the ratings agency Standard & Poor's lowered America's AAA bond rating for the first time in the country's history, to AA+ for long-term securities. The final agreement last summer was conditioned on finding a permanent solution for reducing debt, failing which automatic cuts in budget expenditures, and increases in income taxes, would kick in beginning January 1, 2013. Thus the the second short-term issue, dubbed the "fiscal cliff". The cliff measures would reduce the deficit next year, but so dramatically and suddenly (about 5% of GDP in a full year) that the current, quite fragile improvement in the underlying economy would be flattened. Hardly any way to run fiscal policy.

The third issue, for the long-term, is how to strike a "grand bargain" of restoring fiscal policy balance over the coming decade. As before the November election, the American government is split. House Republicans insist that tax rates must not be increased, and that entitlement and discretionary government spending is the problem. The Democrats in the Senate and the White House, with an eye on income inequality, are focused on raising income tax rates, and other taxes, on the rich, as an essential condition for considering expenditure limits.

Debt levels mean that neither approach could, under any conditions, be sufficient on its own. And economic growth, which by definition improves the debt-to-GDP ratio, will continue to be anemic in the absence of political compromise leading to sound fiscal policy.

It's not dramatic to say that what happens in Washington over the next few weeks regarding these three issues will be the principal determinant of the health of the world economy for the next several years.

Europe Update

As widely thought, EU Finance Ministers meeting on November 12 did not release the latest $40 billion installment of the Greek bailout loan.  The Greek parliament passed both another series of austerity measures on November 8, and the 2013 budget on November 11. These moves, however publicly lauded in Brussels, were regarded as necessary, but clearly not sufficient, conditions for unlocking more rescue funds for Greece. German Finance Minister Schaeuble in particular is waiting on the the latest audit report of Greek finances from the troika of international lenders (the EU, the European Central Bank and the IMF). Greek governments have consistently missed earlier budget and reform targets, and German cynicism persists. The Ministers, while agreeing to extend Greek fiscal targets from 2014 to 2016, will meet again on November 20 to re-assess the additional $40 billion loan installment.

But this could be another difficult meeting. Initial indications just coming out today from the troika report apparently point to an even deeper Greek recession than previously thought. Debt to GDP ratios may thus worsen further for several more years before any improvement can be reasonably expected.

For this writer, these developments suggest this - a program of Greek debt forgiveness, or at least re-scheduling, rather than more loans, is both realistic and, at some point, inevitable. Watch as Ms. Lagarde from the IMF becomes a strong advocate of writing off some of the debt.