Thursday, April 14, 2011

That’s more like it, Mr President

In one of the best political speeches I’ve read in a long time, the US President has outlined his proposal to cut US$4 trillion from budget deficits over the next 12 years. This is a combination of US$3 trillion in spending cuts (including savings on interest costs of a lower debt burden) and US$1 trillion in higher taxes.

The President’s plan compares with a Republican proposal to cut the deficit by US$4.4 trillion over 10 years, solely through spending cuts. The political battle lines for the 2012 election are being drawn.

The President’s Budget proposal will see the budget deficit down from 10.9% of GDP this year to 2.5% of GDP by 2015 and then to around 2% by 2020. This meets the commitments made by the G20, of which the US is of course one, to reduce budget deficits to under 3% of GDP by 2015.

Hopefully, now that both the Democrats and the Republicans are talking medium-term plans, it will move us out of the petty squabbling over the more immediate, but less important given the bigger challenge at hand, conversations like the $38 billion in spending cuts agreed to last week. It would be premature to completely discount further squabbles, however. The next challenge is to agree the raising of the legislated US debt ceiling, the breaching of which is fast approaching.

It’s the medium term outlook that is most important. When we first started talking about exit strategies (yep, in 2009) we said governments with big deficits and high debt needed to articulate credible medium-term strategies for fiscal consolidation to soothe market concerns about the outlook. This did not mean that big budgets cuts needed to happen immediately, but markets needed to understand what the plan was. It was some European government’s inability to articulate such plans that has contributed to bond market nervousness in recent times.

Fiscal consolidation is still a balancing act. Some will argue that the proposed deficit reduction is not fast enough and that spending cuts are not deep enough. Others will argue that further stimulus is still required to support a still fragile economy. I’m happy to sit in the middle. Growth is becoming increasingly private sector led but will be able to sustain a gradual withdrawal of fiscal stimulus.

It’s also important the Government plots its own course to fiscal consolidation before bond markets start to fret and request more immediate action. Better to do it to yourself than have it done to you!! The US can only rely on its position as having the reserve currency for the world while there is still appetite for its debt instruments.

It is also important the Federal Reserve understands the outlook for fiscal policy. This will be an important factor in the FOMCs monetary policy considerations. One of our themes for 2011 is the interplay between fiscal and monetary policy. Stimulus withdrawal (when the time is right) needs to be a highly collaborative exercise. Well articulated fiscal plans will enable better co-ordination and better monetary policy decisions and outcomes.