by Piet Coetzer

World economy

Fiscal cliff complicates US financial future

US Federal Reserve
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The global economy and financial systems seem to be heading for what could turn into a perfect storm in 2013. The United States encountering a fiscal cliff at the end of December this year on top. Then there is the lingering financial crisis in Europe, major stresses in the financial and banking industries, talk of a 'triple-dip' recession looming in Britain.

Thus far the European crisis and the presidential election have kept the spotlight away from the fiscal problems of the US but on 31 December a tranche of tax breaks expire and by March budget cuts worth $607 billion will take effect. That is if a compromise cannot be reached within the deeply divided US Congress.

An austerity programme of this magnitude, far above those instituted in the worst crisis-ridden countries of Europe, would cost the American economy an estimated 5.1% in GDP and push it into deep recession.

While US public debt is set to rise to an unsustainable 90% of the country’s GDP before the end of this decade unless something is done, the International Monetary Fund (IMF) recently said that the “first priority for US authorities is to agree on and commit to a credible fiscal policy agenda that places debt on a sustainable track over the medium term”.

The IMF also warned of the threat of a global recession, a forecast attributed to both the euro crisis and American fiscal policies. The Fund said it could not see how the US would manage to deal with its major budget problems in the medium term. In the short term it warned that the US presents a threat to the global economy.

The growing crisis in the US is also starting to seriously spook its northern neighbour, Canada. Prime minster Stephen Harper went on record to say it is imperative that the US president and newly elected congress focus on improving the US federal government’s fiscal health. The biggest immediate threat he identified as still being the eurozone fiscal crisis, but as the world’s largest economy and most important Canadian customer, the inability of the US government to deal with its debt and annual deficits is  only concern number two.

Barring some sort of compromise being struck between Republicans and Democrats in the US Congress before the end of this or early next year, the US might outrank Europe as the biggest threat to the global economy.

And it is not only the federal government’s fiscal position that precipitates a crisis. There might be a  surprise  lurking in the American banking system where some $230 trillion of so-called derivatives resides. Five of the largest banks are holding $226 trillion in derivatives in a highly leveraged environment. JPMorgan, for example, holds $70 trillion in derivatives and only $1.8 trillion in assets.

Not too dissimilar to the situation in Europe, some of the  US's states are also running on substantial deficits. According to a compilation done last year by the Economist journal over the period 1990 to 2009 US states like New Mexico, Mississippi and West Virginia received annual subsidies of more than 12% of state GDP. While not a perfect measure of subsidy, it conveys the basic point well: Greece’s entire 2011 deficit was 9.1% of GDP.

From the other side of the Atlantic the latest news has also not been encouraging.

German chancellor, Angela Merkel, said the eurozone will take at least another five years to recover from the crippling debt crisis, which is now also hurting Europe’s strongest economy.

France has slipped into a severe recession and the British economy may have contracted again in October, raising the spectre of a triple-dip recession, Chancellor of the Exchequer George Osborne has warned.

A study by a German think-tank concluded that an exit by Greece from the eurozone would cost the global GDP €17 trillion and plunge the global economy into recession.

In the meantime, the latest figures show that the eurozone’s  manufacturing sector has  contracted for the fifth  quarter in a row as output and new orders fell again in October.

Signs of other stresses in the financial system that can have serious economic implications, include:

·  As the debt crisis and artificially pegged interest rates make government bonds and bank bonds increasingly unattractive, institutional investors sit on huge cash reserves that they find difficult to place. Some observers are starting to refer to an “investment emergency";

·  Tension is increasing between both European states on the continent and between the EU and the United Kingdom over bank/financial reforms in the EU, with UK claiming some UK banks could be shut down or forced to seek taxpayer-funded bail-outs if “banking union” proposals go ahead;

·  A rash of banking scandals has seen insurance companies complaining that they are at risk of being caught up in the regulatory crackdown that followed;

·  Bank of England deputy governor Paul Tucker warned against another taxpayer bail-out of banks and said banks must be able to fail. Last year he warned about the possibility of a collapse of the entire banking system. In his latest warning directed at the sector he said the “worst may still be ahead";

·  Plans are afoot in Europe to separate investment banking, which is often high risk, from retail banking to protect the interests of depositors; and

·  So-called high-frequency trading on equity markets. This is facilitated by modern electronic communication and is based on mathematical models where positions  at times are only held for seconds to capture gains of a fraction of a cent. It now constitutes as much as 70-80% of equity trades and scares traditional investors away.

To all of this, food prices, on the back of the worst drought in 50 years in the US, are expected to reach an all-time high in the first quarter of next year, can be added . The increasing danger of a major conflict in the Middle East, starting in Iran and/or Syria adds to instability.

All indications are that 2013 could become a very stormy year on the financial and economic front.


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