Cheerfully Optimistic

US financial markets are remarkably sanguine about imminent, new displays of ineptitude in Washington.

Thus, the principal US stock market indices are all up significantly, from the beginning of this year, from a year ago, and from five years ago. Here, for example, are the data (at date of writing) for the S&P 500 index, a broad measure of the stock market: up 4% from December 31, 2012, up 15% from a year ago, up over 4% from the Spring of 2008, and closing in on its 10-year, pre-financial-crisis peak set in the Fall of 2007. Data for the Nasdaq market (the second-largest stock exchange by market capitalization in the world) are even more dramatic - its composite index is nearly 20% above its previous 10-year peak set in late 2007 (albeit well below its "dot-com" bubble level registered 12 years ago). The Dow Transports index, the oldest stock index still in existence, and regarded as a predictor of economic growth, is at an all-time high. The VIX (the CBOE Volatility Index), considered a measure of stock price volatility and referred to as the "fear" index, has dropped nearly 40% in the last 3 days alone, from already low levels. And finally, while there has been recently a greater relative flow of funds into stocks, the US bond markets, where the world keeps showing up to buy American debt, remain strong and stable, that is, prices are historically high, and yields (which by definition fall as prices rise) are near historic lows for all maturities.

Taken together, this is an unusually bullish picture. The Washington "cloud", with another debt-ceiling negotiation next month, massive government expenditure cuts now set for March 1, unless Congress acts (the so-called sequester), and the continuing resolution of the 2013 US budget later in March - all these seem to matter for not. Markets like current fundamentals - corporate earnings are good, labor markets are showing further improvement, the auto and housing markets are stabilizing, with housing prices and starts up, and foreclosures down, sophisticated manufacturing is returning to America as the domestic energy markets transform themselves, China, and even Japan, look brighter, Europe is at least not about to implode (witness the Euro resurgence), and general price inflation is still no where to be found. 

Upcoming US government antics are, according to the markets, soap opera. The ever-louder rancor over the next few months will present wonderful stock-buying opportunities. Complacency about the long-term debt position in America is the one, serious underlying threat.

Happening Again?

History is replete with examples of countries, beaten in war and/or mired in economic stagnation, ultimately seeking resurrection through radical nationalism. Germany after World War I is perhaps the most obvious example from recent history. The Treaty of Versailles in 1919, ending that war, leveled stringent treaty obligations upon the defeated Germany. Not only were massive, and completely unaffordable, reparation payments imposed, but, under Article 231 of the Treaty, Germany was forced to accept the entire responsibility for initiating the conflict - the so-called "guilt clause". Germans were humiliated; the economy entered a period of hyper inflation, then depression; and the rest of the tragic story, with the rise of Nazism, is only too well-known.

Japan, with quite different timing and circumstances, is - startlingly - exhibiting early signs of a similar kind of extreme nationalism.  First, a bit more history: with its defeat in World War II, Japan was occupied by the United States (1945-52) under General MacArthur, who, rather than simply imposing reparations, initiated a sweeping range of military, economic, political and social reforms. Punishment was exacted through the convening of war-crimes trials in Tokyo. A new constitution was implemented, committing Japan to pacifism. But the Americans regarded the economic rehabilitation of Japan as crucial, especially as a counter to the emerging threat of communism in China, and this focus helped set the stage for what would become the Japanese economic "miracle" over the subsequent four decades. Fast forward to the 1980's and Japan was the second largest economy in the world, and as an economic force seemed unstoppable.

But the story has changed completely since then. With the bursting of a massive property bubble in 1991, Japan has been stuck in an economic bog, unable to spark  growth on anything approaching a sustainable basis - even with repeated rounds of fiscal (and monetary) stimuli so large and frequent that the outstanding national debt is now equivalent to over 200% of GDP. In the context of its third recession in only the past five years, Japanese voters have just re-elected Shinzo Abe as their next Prime Minister (he was last Prime Minister in 2006-07), and his Liberal Democratic Party won two-thirds of the seats in the lower house of the parliament. Mr. Abe's new Cabinet, introduced late last month, is, if nothing else, a study in something approaching extreme nationalism. As one example, the new Education Minister has announced his intention to re-align the teaching of history in schools in a way that would gloss over Japan's militarist era, and he wants to annul both the 1995 "Murayama statement", which formally extended an apology to Asia for Japan's war-time atrocities, and even the verdicts of the Tokyo war-crimes trials of 1946-48. The Minister is strongly supported by nearly all his new Cabinet colleagues. For his part, Mr Abe has already managed to alarm both the Chinese and South Koreans, escalating the territorial disputes over the Senkakus and Takeshima islands, and promising to strengthen relations with America as his "first step in turning Japan's foreign and security policy around".

Immediately after his re-election in November, President Obama visited three Asian countries - Cambodia, Myanmar, and Thailand. The trip was a clear demonstration of a new focus on Asia in his second term. Such a focus now appears prescient in light of, among other things, these disturbing political developments in Japan.

More Brinkmanship

There's really no end in sight for America's fiscal mess, and its political brinkmanship. Congress' after-midnight-New-Year's-day-2013 patch did almost nothing to reverse a now 4-year string of annual trillion-dollar budget deficits, or the cumulative outstanding US government debt of some $16 trillion (an amount that now exceeds the nominal value of the entire US economy). The New-Year's day deal, which among other measures raised tax rates for the top 1% of income earners, and left everyone else's unchanged, may increase government revenue by some $66 billion in a year, an amount equivalent to about 0.5% of total government debt. Even President Obama conceded that "we still have deficits that have to be dealt with", perhaps the understatement of 2013.

For several years now, US politicians have decried the political and economic dysfunction in Europe - rightly so. But to view incompetence on at least a comparable scale, they need only gaze into the nearest mirror. America will once again be stepping to the edge of a cliff some time in February, when its leaders will fight again over raising the debt ceiling. Lines in the sand have been drawn already. They were last drawn in the summer of 2011, when, although the borrowing limit was ultimately raised (for the 11th time since 2001), politicians essentially agreed they couldn't agree about fiscal policy, and America's credit rating was promptly downgraded. Thus, a few days after the New-Year's deal, Republican Senate Minority Leader, Mitch McConnell, drew his line: "The tax issue is finished, over, completed. President Obama got his rate hike in last week's fiscal cliff deal. Spending cuts must be the agenda from here", and, "Now that we have resolved the revenue issue, tax reform ought to be revenue-neutral". Democratic House Minority Leader, Nancy Pelosi, simultaneously drew her line, noting "we got high-end tax, changing the rate to 39.6%, but that is not enough on the revenue side", and concluded, "any link between raising the debt ceiling and cutting spending won't happen".  In his weekly address to the nation on January 5, President Obama weighed in as well, saying "he will not compromise" over his insistence that Congress lift the federal debt ceiling, and that, "the consequences (of not doing so) for the entire global economy could be catastrophic".

America technically reached its self-imposed borrowing limit late last month, but the Treasury Department has used some accounting tricks to postpone the inevitable for a month or two. Watch as the Republicans, still smarting from their tax rate compromise last week, use the debt ceiling negotiations as leverage to enact government expenditure cuts. And watch Democrats fight to "protect seniors and the poor". And most importantly, watch for new statements from the world's bond-rating agencies, as America's debt clock keeps ticking.

The IMF is Back

International Monetary Fund (IMF) officials returned to Cairo yesterday. Discussions regarding a $4.8 billion debt-relief loan, halted last month when Egyptian President Morsi abruptly cancelled planned tax increases and other measures aimed at curbing a burgeoning budget deficit, have apparently resumed. Mr Morsi had clearly decided in December that the imposition of severe austerity measures would hardly be conducive to his priority of pushing through a controversial referendum to endorse a new constitution.

In the ensuing weeks, the atmosphere surrounding negotiations with the IMF has, if anything, become even more difficult. Loans from "Western" institutions are widely unpopular in post-Arab-Spring Egypt, and are especially difficult to contemplate for President Morsi's Islamist-inspired government. But bail-out money is now crucial - economists at HSBC warned yesterday that "if IMF funding is secured, things will be tough. If it is not, economic deterioration could be disorderly and painful".

Here's the litany of economic woes in Egypt as it re-negotiates with the IMF: growth is in free-fall, particularly in the private sector, as exports. new orders, and tourism have dropped (many hotels are empty; Nile cruises ceased over the Christmas high season); scarce foreign exchange reserves at the central bank are being depleted, as authorities fight to stem a run on the Egyptian pound (the currency has fallen over 10% since the Arab Spring uprising in February 2011, a decline which is accelerating in recent weeks); Egypt's annual budget deficit is most recently estimated at 10% of GDP, higher than even the worst positions in the Euro zone, and clearly unsustainable in the eyes of bond investors who have driven yields for even one-year financing instruments to above 14%; the country's current account deficit exceeds 3% of GDP, suggesting a looming, full-blown balance of payments crisis. On top of all this, as a condition of the IMF loan, austerity measures that raise taxes and lower or eliminate subsidies will be required, only adding to the domestic turmoil characterizing Egypt for nearly two years.

Here's this writer's advice to President Morsi: begin focusing a little less on transforming Egyptian society into an Islamic state, and a bit more on economic issues. Economic crises have a way of sweeping away political regimes of any bent. 

Lighter Than Lite

It's been said that America is one big debt deal away from restoring greatness - or, at least, economic prosperity. On the first day of the new year, it looks like greatness will have to wait.

No one can recall the last time the US Senate passed legislation just after midnight New Year's Day (likely never), but just that happened today. The fiscal cliff, bi-partisan deal, passed early this morning by an 89-8 vote in the Senate, makes permanent - except for the "wealthy" (defined here as individuals earning more than $400,000, and couples earning more than $450,000) - the income and capital gains tax cuts first implemented by the Bush administration in 2001 and 2003. These were to expire on December 31, 2012, in which event the hit would have been more than $300 billion, equivalent to about 2% of GDP. Benefits for the long-term unemployed are also to be extended. America's economy is recovering, but only very gradually, and it could not have weathered such a large and abrupt policy contraction - a "cliff" effect. Hence, the urgent, last-minute, into-the-night, final-shot negotiations in the Senate.

The deal also addresses to some extent another element of the fiscal cliff  - automatic government spending cuts (referred to as a sequester) spread about equally across defence and domestic discretionary programs. Some $100 billion of these scheduled cuts - which, like the tax hikes, would have acted as a drag on still-fragile economic growth - are to be deferred for two months, allowing legislators to re-assess. Republicans in the House, where the bill is now moving for a vote later this afternoon, will certainly see this as yet another example of kicking the proverbial can down the road. Spending is the issue, in their view, as budget deficits have exceeded $1 trillion, or 7% 0f GDP, in each of the last four years of the Obama administration. The Senate bill does nothing in this regard, so that the long-term trajectory of government debt, which now exceeds $16 trillion - an amount greater than the value of the entire US economy - remains dismal.

Reform of the tax code, and of entitlement expenditures, are the really hard parts of any comprehensive debt deal. These issues will require intensive negotiations as America reaches its self-imposed debt ceiling, likely sometime in early February. Even if the House passes this lighter-than-lite Senate bill this afternoon, the dark cloud of government debt and political paralysis will continue to hang over the economy and investor confidence. The "grand debt bargain" remains elusive.