The American Economy: Proceed with Caution

America’s economy looks set for a good year. But investors should beware the treacherous path beyond 2011
The American economy Dec 29th 2010 | from PRINT EDITION


THE American stockmarket enters 2011 in a jolly mood. In the past four months it has leapt by 20%, to heights last enjoyed when Lehman Brothers was a going concern. Investors are likely to cheer a second consecutive year of double-digit returns.

This partly reflects growth elsewhere: American companies make a third of their profits outside the United States. But the most recent spurt has been driven by a sharp change in the outlook at home. At the end of the summer Wall Street worried that growth was grinding to a halt. The Federal Reserve was running out of monetary ammunition. The incremental contribution of Barack Obama’s $814 billion stimulus had faded and a gridlocked Congress seemed incapable of supplying new support. Big business was rattled by Europe’s sovereign-debt crisis. Wall Street’s bears sniffed deflation.

What has changed? In part it is simply a case of the underlying American economy turning out to be stronger than pessimists imagined: consumer spending, business investment and job creation are all up lately. But policymakers have also done their bit. In November the Fed began a second round of “quantitative easing”—buying bonds with newly created money in order to push down long-term interest rates and stimulate lending. And in December Mr Obama and the Republicans agreed to extend George Bush’s tax cuts until the end of 2012 and to pump a further $300 billion into the economy in 2011 through a payroll-tax cut and other measures. The deal should spur growth; it also got rid of the (until then very real) danger of inadvertent fiscal tightening tipping the economy back into recession. That is the main reason why bond yields have risen with share prices. Bolder investors are less willing to accept rock-bottom yields in return for safety.

This bipartisanship will bankrupt us

Put these things together, and the American economy could grow by nearly 4% in 2011: so Wall Street is right to be cheery on that score. But share prices are meant to be based on more than just the next 12 months’ earnings, and the medium term is as treacherous as ever; perhaps more so.

Start by noting that the recovery is subdued by historical standards. This is not because of high interest rates or frail business confidence, the sorts of things that a well-honed stimulus might quickly cure. Rather, households and banks are working off the excess debts of a reckless decade. Monetary and fiscal easing should make this less painful, but this deleveraging still has years to go. There will be more weak patches like the summer of 2010, when investors’ joy may quickly turn to gloom.

Next, the new tax deal has made America’s long-term fiscal problems even more intractable. The payroll-tax cut may well not expire in a year’s time: it will be portrayed as a tax increase when unemployment is still high. But the real problem is the Bush tax cuts. Optimists hope that their expiry in 2012 will allow a grand bargain to be agreed before then: the lower tax rates could be kept in exchange for a plan to stabilise the federal debt as a share of GDP by closing loopholes and cutting spending. A good idea, but both Mr Obama and the Republicans are hellbent on fighting the next presidential election over the tax cuts (with Mr Obama keen to let the cuts for the richest Americans lapse). Neither side has much incentive to fix the problem before 2012 as part of a longer-term deal.

Much worse is what the deal says about the nature of bipartisanship in today’s Washington. The Republicans and Democrats merely agreed to each other’s huge giveaways. Real bipartisan budgeting must involve far more painful things —increases in taxes and cuts in entitlements. The politics of cutting health care and pensions is getting worse. In 2011 the first baby-boomers retire and the number of elderly voters will only grow (see article). The Republicans claim they are ready to reform Social Security and the tax system. A wise Mr Obama would call their bluff by presenting a plan for both in his budget. But don’t bet on it. The longer both sides drag their feet, the more likely a revolt in the bond market and a skint Treasury squeezing American businesses for cash.

Wall Street may be right about the economy in 2011. But the American government’s inability to sort out its finances in a credible way should unsettle investors everywhere.

from PRINT EDITION | Leaders