Tuesday, 26 July 2011

One week to go

It is the 26th of July today and there remains exactly a week to go for the 2nd of August, 2011. Sometime between then and now, the Congressmen in Washington D.C will need to arrive at a compromise to ensure that the debt limit of US$ 14.3 Trillion can be raised, failing which the Government of USA faces the prospect of defaulting on its financial commitments.

Should the Republicans and Democrats fail to arrive at a compromise, the outcome could be a disaster with few parallels in the recent past. With most international trade denominated in dollars, a fall in the value of the dollar (which is bound to happen should the default come to pass) will have an adverse impact on exports. Contries like China and Germany, which are heavily export oriented would be the worst affected.

For China, the blow could be on two fronts. For one, the impact on its exports could be significant. Having artificially devalued their currency for so long, the Chinese will need to do a complete overhaul of their economy to reduce their dependence on exports. Secondly, with over a trillion dollars parked in American treasury bills and a higher figure held in foreign exchange reserves, a sudden drop in value will result in a collosal loss. Should the effect on the Chinese economy be severe, we face the prospect of the three largest economies in the world slipping into a vicious spiral (USA and Japan are already in the throes of a seemingly never-ending crisis).

But from a purely American perspective, it remains to be seen how they manage to contain the burgeoning fiscal deficit. Even allowing for the fact that they manage to arrive at a compromise and raise the borrowing limit, its just a case of delaying the explosion rather than diffusing the bomb. With millions of baby boomers set to retire over the next few years, the burden of old age pensions is only set to increase.

For years now, the Government of the USA has been meeting its obligations through debt financing. As long as the economy was sound, there were enough and more investors willing to invest in US treasury bills. The fact that the US Dollar was the most commonly used currency enabled Washington D.C to run on massive budgetary deficits, secure in the knowledge that someone or the other would invest in their bills. But with the prospect of a default looming and the fact of the economy already being deep in recession, it remains to be seen how many investors will be keen on parking their funds in US debt instruments.

Already, five rising economies (BRICS- Brazil, Russia, India, China and South Africa) have signalled their intention to establish mutual credit lines by denominating trade between them in their local currencies. While the modalities of that proposal are yet to be worked out, there's little doubt that the process is going to be accelerated in the light of the impending crisis in the USA. In the medium to long run, there is the very real prospect that more countries will be looking to establish a similar framework with key partners. Should that come to pass, the American Government will find it increasingly difficult to finance its massive budgetary deficits.

The other option normally available would be to channelise domestic savings through the financial sector. But America's consumerist policies which have emphasised expenditure over savings means that the average household simply doesn't have the means to invest in savings instruments. According to the Consumer Credit report issued by the Federal Reserve (8th July 2011), the total consumer debt stands at a staggering 2432 billion. With a population estimated at 308.7 million (according to the 2010 census), it means that the average citizen of the USA is indebted to the tune of US$ 7,878 or so. Given such staggering debt levels, it looks highly unlikely that there is going to be adequate disposible income to be channelised.

In other words, the United States of America is in urgent need of financial restructuring if it is to implement a policy of greater fiscal prudence. For starters, they will need to find ways of changing the spending habits of its citizens. The days of indiscriminate borrowing and spending will have to go, which can be achieved through a combination of fiscal incentives for saving and a tightening of the rules relating to lending. There also is the challenge of increasing the taxes, the bone of contention between the Democrats and Republicans. Much as Americans may resent higher taxes, they need to realise that their Government simply does not have a second choice in this matter.

There is no doubt that such sweeping changes, which would affect the way Americans have lived over the last three decades, will be virtually impossible to implement in the short to medium term. Until then, the USA's budgetary deficit will only keep mounting, which is bound to fuel inflation. In short, the average American citizen is bound to suffer the dual burden of unemployment and rising prices.

In short, the only solution is short term pain for long term gain. Whether the people of the USA and their leaders have the will and the courage to implement it is the bigger question.

Irrespective of what happens between now and 2nd August, the USA is sitting on a bomb waiting to explode.

1 comment:

MS said...

This article is very informative and gives a comprehensive perspective on the state of the American economy. The author has researched deeply and has shared his views in a very candid manner. Congratulations to the author for writing a very well researched story on the sate of the American economy.