George Kerevan: Misfiring in the engine room is a major worry for Uncle Sam

Published on Thursday 9 June 2011 22:43

Could America really default on its sovereign debt? It is saying something about the current uncertain state of the US economy that the three major rating agencies are hinting about downgrading the "triple-AAA" status of the world's largest and most productive economy.

Of course, no-one actually expects the US government not to pay its debts. In reality, the rating boys are signalling to the warring factions in Congress to get their act together and do something about the deficit. And to President Barack Obama who heads the only administration in the Western world still pursuing an expansionary fiscal policy.

It has not been a good week for investors anxious that US politicians agree a plan to sort the American economy. On Monday, Nobel Prize-winning economist Peter Diamond withdrew his nomination for the Federal Reserve board, complaining that Republican ultras had blocked his confirmation.

It is a sign of the insularity and lack of direction in US politics at the present moment that the Republicans are willing to politicise the Fed just as the global economy shows signs of increasing instability - witness the failure of Opec this week to agree a production increase, or the eurozone sleepwalking towards an inevitable Greek default.

Underlying all this is a permanent uncertainty regarding what is happening deep down in the engine room of the US economy. Unemployment climbed to 9.1 per cent in May, confounding predictions of economic recovery. And the reliable S&P/Case-Shiller index showed house prices fell 4.2 per cent in the first quarter, the biggest drop since the start of 2009. This suggests the US is ambling towards a double-dip recession when the Fed's latest $600 billion (370bn) round of quantitative easing (QE2) ends this month.

On the other hand, there has been some positive data this week. The US trade deficit narrowed in April and a second straight month of record exports helped Wall Street end a six-day losing streak. On Monday, Apple announced its new cloud computing product, showing America is still leading the world technologically.

The fault in the economic engine room is this. US hi-tech manufacturing and exports are booming but the spurt in productivity and sales is not feeding through to job creation. At the same time, stagnant wages, high fuel costs (for Americans) and soaring food bills are holding back consumer spending. As a result, the US economy slowed substantially in the first quarter, dropping from a growth rate of 3.1 per cent to just 1.8 per cent.

This sounds very much like the UK situation. The difference is that the coalition government in Britain is pursuing an austerity policy and curbing fiscal expansion (though by less than popular perception imagines).In America, on the other hand, this year's budget deficit is projected to reach $1.5 trillion. The previous record, in 2009, was $1.4tr.

There is pressure on the White House and Congress to agree a long-term plan to trim the deficit. But Democrats and Republicans are at loggerheads on how to do this. The left wants tax increases while the right wants spending cuts. Currently there is a deadlock - hence the intervention by the rating agencies. The policy gridlock has a lot to do with the proximity of next year's presidential election. Don't expect a fiscal consolidation till after November 2011.

The only institution with room for manoeuvre in the next few months is the Federal Reserve. The Fed differs from the Bank of England in having a dual mandate to maximise employment as well as maintain price stability. It was this need to boost growth that led the Fed to implement its second round of quantitative easing last November. Might it go for QE3?

The US stock market dropped substantially in 2010 following the end of the Fed's first quantitative easing. Coupled with the recent economic wobble, this has led some commentators to predict QE3. Others are not so sure given the return of inflation.

Which way will the Fed jump? The dovish head of the Boston Federal Reserve, Eric Rosengren, thinks that if fiscal policy is tightened by Congress then monetary policy should be eased. Congressional Republicans are opposed. The decider will be what happens to US unemployment.

But insular America is forgetting one thing - the amount of US funds invested in eurobonds. America might not default but Greece will. The repercussions will not stop on this side of the Atlantic.