Comment: Hope on horizon, but Detroit is a warning

Detroit has filed for bankruptcy but it's high summer in the markets. Picture: Reuters
Detroit has filed for bankruptcy but it's high summer in the markets. Picture: Reuters
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A new record high for the US stock market, but the city of Detroit in bankruptcy: two astonishing sides to the paradox of modern America.

How could its once great industrial city present itself as a failed city state, while one of the iconic barometers of the country’s wealth hits new peaks?

There are haunting echoes here. Could the same schizophrenic vision unfold in the UK: a residual, technology-driven stock market close to new highs of confidence, while our former industrial heartlands fall further into decline and decay as a debt-ridden government finds its welfare commitments unsustainable?

The financial failure of Detroit will confirm the fears of many that the rally that took the S&P 500 to new highs last Thursday is a very misleading measure of the health of America.

As resonant are the unsettling pictures long closed factories, rusting machinery, industrial wasteland and thousands of abandoned homes. Detroit once boasted the highest percentage rate of owner occupation in America. Now 70,000 properties are being left to rot.

Governor Rick Snyder has sought to cast the best possible PR spin on the city’s financial failure; that the move will reverse decades of decay. It is hard to see how.

The birthplace of the car industry has collapsed under the weight of $18 billion (£12bn) of debt and public sector pension obligations. The city’s creditors are now being paid 38 cents for every dollar they are owed. Now they are being asked to accept just ten cents. Some $9bn is owed to
pension funds and those providing healthcare benefits for 10,000 workers and 20,000 retirees. Little wonder that pension funds have mounted a legal challenge to the bankruptcy order.

“So what?” seems to be the response on stock markets. Both the US S&P 500 and the UK’s FTSE 100 have rallied strongly in the past month, as Ben Bernanke, the chairman of the Federal Reserve, soft-pedalled on previous statements about a rapid withdrawal of its monetary stimulus programme – so-called quantitative easing. By the end of last weekend the FTSE 100 was up nearly 15 per cent since the start of the year, while the US stock market index had soared by more than 29 per cent since January.

In this striking paradox is there much that is really new or to be concerned about? Stock markets have historically mounted strong rallies in the midst of the most dire economic circumstances, investors taking the view that a bottom has been hit and a turnaround not far off. Conversely, stock markets can plunge in the middle of economic booms as investors fear a credit crunch plunging from out of a clear blue sky.

This time, however, the budgetary problems we face are colossal and the social consequences as shown by Detroit appalling. Markets may be enjoying the uplift in corporate earnings as the digital revolution gathers force. But there is a massive overhang of social and welfare obligations to which the word “unsustainable” now seems permanently attached. There is something much more worrying here than a conventional cyclical rebound can address.

Here in the UK, the Office for Budget Responsibility reminded us last week not just of further – and deeper – austerity immediately ahead, but a demographic “long tail” that looks set to drive public debt to even higher levels than today. On a medium-term view, the budget deficit will start to climb again, forcing public sector net debt “on a continuously rising trajectory as a share of national income”.

Public debt, it warns, will climb to 99 per cent of GDP unless something is done about the demographic time bomb. Either there is some transformational new technology developed by a new generation of entrepreneurs, or we could find ourselves facing a future as bleak as that of Detroit.

But is not America now enjoying a robust recovery which will melt those black clouds? It is certainly true that – outside of Detroit and other areas in economic
decline – a robust housing recovery is under way. But this is not – or not yet – an all-powering revival.

The advance report on US second-quarter GDP is due to be published on 31 July. This is likely to show that after two quarters of disappointing growth, GDP will have again fallen well short of its trend rate of expansion. Indeed, a significant overall slowdown in consumers’ expenditure looks likely. Government expenditure has been cut back and business investment lacks momentum.

In a typical upswing, growth here would be stronger. But, as Monument Securities economist Stephen Lewis notes, “businesses seem to lack the confidence to step up their capital spending and are intent on using whatever financial leeway there is to reward stockholders.”

Without a faster rate of growth from this anaemic level America’s central bank will find it very difficult to wean the economy off emergency monetary support. And I suspect the same will prove true here. There are good reasons for investors to be cautious about this stock market rally continuing into the autumn, and for us to focus on where ever-rising debt and unsustainable spending and welfare commitments could lead. That is the message that Detroit poses, for America and the debt-laden economies of the West.