Making sense of the US mess

“When the US sneezes, the world catches a cold,” so goes a popular adage. And it was never truer than during the past few days when the financial markets in the world, including the Philippines, gyrated wildly after the credit rating of the United States was downgraded by Standard & Poor’s (S&P). Economists may understand the ins and outs of the turmoil but non-eggheads like me need to make sense of it in less technical language, in terms of how it originated, how it can be solved, and how we, in the Philippines, can cope with it.

How it started. In 2001, the United States registered a budget surplus, because it spent less than it earned (mostly from taxes). However, during the last 10 years, the US reverted to deficit spending. By 2011, its debt rose rapidly to an incredible $14.3 trillion, mainly because it reduced taxes, funded two wars in Iraq and Afghanistan, and sharply increased public spending to mitigate the 2008 financial meltdown. It financed its deficit mainly through borrowings. It is like a family that spent more than it earned, and financed its purchases of foodstuff, medical care, housing and travel through credit cards, installment sales and bank loans.

Some two weeks ago, the US was in jeopardy of “default” (inability to make timely payment of its maturing principal and interest) because it reached the statutory borrowing limit. The US Congress needed to pass a new law that would enable the government to resume borrowing, an exercise that was done routinely in the past.

This time, however, Congress was divided. The Republican Party that controlled the House of Representatives wanted the government to decrease its expenditures as a condition to increasing the debt limit. This would mean cutting Medicare, social security and retirement benefits, which the Democratic Party led by President Barack Obama opposed. Instead of cutting expenses, Obama wanted to increase taxes. There was a clash of economic philosophy on how to solve the debt crisis: to cut spending or to raise revenues via new taxes.

Solution to the turmoil. After several marathon meetings, Congress decided to raise the debt limit and to reduce expenses by about $1 trillion over the next 10 years. It also created a “super” committee composed of six senators and six congressmen to seek new ways, by Nov. 30, 2011, of further cutting expenses by another $1.5 trillion.

S&P was not impressed by the solution. It believed that the spending cut was insufficient to stabilize the debt trajectory and that the political gridlock in Congress weakened the effectiveness, stability and predictability of American policymaking. So, it downgraded the credit rating of US debt instruments one notch lower, from the highest rating of AAA to AA+. This means that the US may have to pay a higher interest rate for its borrowings, thereby bloating its debt even more.

By itself, this downgrade was not the major cause of the turmoil. However, it was the last straw that broke the confidence of creditors in the political will of the US to solve the financial mess. Other than the downgrade, there was the long nagging fear of the much more debilitating debt incurred by European countries like Portugal, Ireland, Italy, Greece and Spain (PIIGS). While these countries’ collective debt was less in absolute amount than the $14.3 trillion US deficit, they had far less ability to pay their debt, given the fundamental structural weaknesses in their economies.

At a time of instability and turmoil, investors sell their stocks in the belief that the economic downturn in the US and Europe will jeopardize their capital. Investors tend to deposit their cash in the banks, or exchange them with more stable currencies like the Swiss franc, or buy fixed rated bonds, or invest in gold bullions.

To ordinary lay people, the remedy is really simple. When a family overspends, the solution is to tighten belts, spend less and earn more. But to governments, it is not that simple because belt tightening reduces consumption, constricts the circulation of money, dampens business activities and causes job losses. In fact, governments tend to do the opposite: to borrow more and spend more to generate economic activities and create jobs.

The better solution is for the US Congress to unwind its political gridlock, find new ways to reduce spending and raise revenues, and enact policies to restore business confidence.

How PH can cope. Meantime, an economic pygmy like the Philippines will have to anticipate and adjust to the consequences of the crisis. One major effect would be the lowering of the price of oil because an economic downturn lessens the demand for gas and leads to the reduction of pump prices of petroleum products.

But it could also mean reduced remittances from OFWs in America and Europe. Some nine million ethnic Filipinos live and work in the US. Because of the turmoil, many will lose their jobs and will thus not be able to remit as much funds to their relatives here. And because the US dollar is weakening, there will be less pesos for the same dollars remitted by Filipino-Americans.

To create new jobs and stimulate business here, the Philippine government, according to Finance Secretary Cesar Purisima, will soon award infrastructure projects to private investors and fastrack growth sectors like business process outsourcing.

In sum, I think our economy is resilient enough to withstand the US and European turbulence and, with proper anticipation and planning, can come out relatively unscathed.

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