A grim economic reality

Editor’s Note: Neil K. Shenai is an Instructor of International Economics and Ph.D. Candidate at the Johns Hopkins School of Advanced International Studies (SAIS).

By Neil K. Shenai - Special to CNN

Since late 2008, when the Treasury and Federal Reserve bailed out the banks, AIG, Fannie Mae and Freddie Mac, commentators have been predicting a sovereign debt calamity for the United States.  These doomsayers argue that runaway deficits and stagnant economic growth, set against a backdrop of political deadlock and a Central Bank that seems content to print dollars and inflate every asset it can, will cause investors to shun U.S. treasuries, sending bond prices down, interest rates up and choking off America’s fragile recovery.

Fine research by economists Carmen Reinhart and Kenneth Rogoff shows that historically, financial crises are usually followed by sovereign debt crises, as states have to battle the twin menaces of falling tax revenues and greater fiscal outlays to counterbalance falling aggregate demand.  With this in mind, it is not surprising that countries like Portugal, Italy, Ireland Greece, and Spain are experiencing sovereign debt crises of their own. 

On Friday, it seemed like sovereign debt woes had engulfed the United States when the S&P rating agency downgraded the sovereign debt of the United States, arguing “that the effectiveness, stability and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned…”

S&P’s Friday announcement became Monday’s catalyst for a broad market selloff, as the Dow Jones Industrial Average fell 635 points, bringing the Dow down to approximately 10,809, far from its fifty-two week high of 12,876.  As is usually the case, when investors question the sanctity of risky assets, they usually sell them in favor of perceived safe havens, such as gold and U.S. treasuries.  Indeed, that is what happened on Monday, as treasury prices rallied because of heightened investor uncertainty.

This is the irony of the U.S. sovereign debt downgrade. Fears caused because of the downgrade induced investors to sell risky assets and purchase safe ones, sending treasury prices up and lowering U.S. interest rates.  In short, the downgrade of U.S. debt paradoxically increased the relative creditworthiness of the United States government.

This phenomenon illustrates an important aspect of the global economy today: there just are not enough perceived risk-free assets to meet investor demand for them.  According to Nomura, an investment bank, the United States accounts for approximately sixty-five percent of all AAA-rated debt outstanding. Fannie Mae and Freddie Mac, America’s housing giants, have roughly three times the amount of debt outstanding when compared to the next-highest sovereign, Germany.  There are other alternatives to treasury bonds, such as gold or metals and minerals, but these assets do not yield any interest and have historically proven difficult to manage as the global reserve asset.  For the foreseeable future, the Treasury bond is here to stay.

So what is all this fuss about? Even though the United States is not likely to default on its debt in the near-term, investors are coming to grips with the economic reality facing advanced economies.  Especially in the United States, this recession was caused by too many consumers taking out too much debt – credit card, mortgage, student loans, you name it – and we are all currently experiencing the hangover after their great credit binge as households pay down their debt and reduce their financial obligations.  Paying down debt does not do much to increase aggregate demand and decrease unemployment, especially when banks are spooked and are reluctant to lend.

Firms, whose balance sheets are lean and clean after deleveraging and cutting costs during the height of the recession, see no reason to deploy capital in the United States for many reasons, including diminished growth prospects, an uncertain political and regulatory environment, and high corporate taxes.  Meanwhile, our political system is mired in partisan deadlock.  Blame whoever you want, but Washington is not going to provide much stimulus to the U.S. economy anytime soon, especially when fiscal austerity is once again in vogue.

There are many sensible public policy choices that can help speed up this recovery, including debt restructuring for underwater homeowners, tax relief for corporations who choose to repatriate their earnings held abroad, incentive reform for health care providers, and even, dare I say, more brick-and-mortar spending on behalf of the Federal government on schools, roads, research and development, and other vital infrastructure.

The danger the United States faces is not one of insurmountable structural problems – compared to the Great Depression or maybe even the 1970s, the economic fundamentals of this current recession are bad but not unconscionable.  Instead, our leaders and the voters who elected them wrongly believed that the worst of the 2008 crisis is behind us – that we are on the road to recovery and normalcy.  But these are not normal times.

The Great Recession is still here and it will not end because of ideological hail Maries and wishful thinking.  Perhaps the market is reacting to its sense that our leaders have somehow failed us – that they did not make the use of the tools available to them to solve the underlying structural imbalances in the U.S. economy, and that they have instead descended into premature near-term austerity that could, ironically, lead to lower future income, lower future tax revenues, and thus even greater future deficits.

Unfortunately, the U.S. economy is weak and there are very few sources of growth available to America in the near term.  America contributes to over 20% of global GDP and has financial and trade links to every relevant economy in the world.  This market sell-off could be seen as the market’s acceptance that stagnation is the new normal.  This is a shame, since America can do far better.

The views expressed in this article are solely those of Neil Shenai.