MacroScope

We heard it more than once at today’s hearing of the Joint Economic Committee featuring Fed Chairman Ben Bernanke: the central bank’s low interest rate policies are allowing Congress to delay tough decisions on long-term spending.

As U.S. senator Dan Coats asked pointedly: “Is the Fed being an enabler for an addiction Congress can’t overcome?”

Yet, if you read the subtext of Bernanke’s testimony closely, it may actually be Congress that is enabling a loose Federal Reserve.

That’s because it is the very fiscal tightening mandated by Congressional inaction that is forcing the Fed to continue stimulating growth. Chicago Fed President Charles Evans said on Tuesday the economy could be expanding as quickly as 3.5 percent were it not for the fiscal drag from Washington.

Bernanke echoed that sentiment in his testimony on Wednesday:

The Congressional Budget Office estimates that the deficit reduction policies in current law will slow the pace of real GDP growth by about 1-1/2 percentage points during 2013, relative to what it would have been otherwise. In present circumstances, with short-term interest rates already close to zero, monetary policy does not have the capacity to fully offset an economic headwind of this magnitude.

U.S. exports posted their biggest drop in nearly four years in October, pushing the U.S. trade deficit higher despite a decline in imports to their lowest level in 1-1/2 years.

The data reveal that U.S. exports of goods and services have now decelerated to a year-on-year growth rate of just 1 percent compared with 2.8 percent in the third quarter of 2012 and 11.5 percent last year at this time, writes Deutsche Bank Securities chief U.S. economist Joseph LaVorgna in a research note.

We are concerned by this export trend, not only in October, but over the past several months, because exports have contributed an outsized share to economic growth in the current cycle. If exports fade away as an economic driver in the near-to-medium term, other domestic engines will need to accelerate in order to pick up the economic slack and maintain growth near 2.0-2.5 percent. We think this is possible if fiscal cliff concerns are adequately addressed. The domestic offset will come from continued recovery in the housing sector, as well as pent-up demand from households and businesses.

The American people have spoken but for the markets the votes of 300 Greeks could be of even more importance in the short-term. German Bund futures have opened flat, not really reacting to Obama’s victory, while European stocks have eked out some early gains.
       
We await a knife-edge parliamentary vote in Athens on labour reforms to cut wages and severance payments, which the EU and IMF insist are a key part of a new bailout deal, but which the smallest party in the coalition government has pledged to vote against. That leaves the two larger parties – New Democracy and PASOK – with a working majority of just nine lawmakers and on a less contentious vote on privatizations, a number of PASOK deputies rebelled. Ratcheting up the pressure is a second day of a general strike which will see thousands take to the streets.

We know that the troika has advised that another 30 billion euros needs to be found to keep Greece afloat. We also know that the IMF has been pressing for the ECB and euro zone governments to take a writedown on Greek bonds they hold, which Germany refuses to do so (which means it won’t happen, for now at least). The Eurogroup is awaiting the troika’s final report and it’s looking less likely that a definitive plan will be signed off at next Monday’s meeting of euro zone finance ministers.

Nonetheless, it’s in no one’s interests to let Greece crash at this point so the presumption is a deal will be done, probably featuring Greece getting two extra years to make the cuts demanded of it, extending maturities on its loans and cutting the interest rates. Talk of the ECB foregoing profits on the Greek bonds it holds (rather than taking a loss, since it bought them at a steep discount) continues to do the rounds. A further German condition is for a ring-fenced escrow account to hold some Greek tax revenues to ensure that it services its loans. Greece will probably also be allowed to issue more t-bills to tide it over though that requires the ECB’s acquiescence since Greek banks are entirely dependent on central bank liquidity and have been offering those t-bills up as collateral. Mario Draghi is speaking today.

The battle over the amount and nature of government spending is the focus of the current U.S.presidential campaign and is unlikely to go away even after the November election is well in the rear view mirror.

In such a setting, a paper presented by economist Albert M. Wojnilower at the October 1983 Bald Peak Conference sponsored by the Federal Reserve Bank of Boston, sounds as timely today as it did then. Wojnilower, then chief economist at First Boston, prepared his “Don’t Blame the Deficit” talk as a commentary on “Implications of the Government Deficit for U.S. Capital Formation,” a paper by Benjamin M. Friedman, a professor of political economy at Harvard.

Here is the jist of Wojnilower’s argument, made almost three decades ago when the Ronald Reagan presidency was almost three years old: If the United States is under-investing, the “villain” is not the Federal budget deficit, he said.

After the EU summit exceeded expectations the more considered verdict of the markets will dictate in the short-term, certainly until the European Central Bank’s policy meeting on Thursday. Previous summit deals crumbled pretty quickly buying only a few days or even hours of market relief.

After strong gains on Friday, Asian stocks are up modestly and European shares have edged higher. However, German Bund futures are nearly half a point higher, so something’s got to give and more often than not it’s the stock market that thinks again. So maybe Friday’s rally was a one-off.

For it to have any legs, the ECB may well have to come up with something on Thursday, and a quarter-point rate cut – widely priced in – may not be enough. ECB policymaker Asmussen is already out saying Greece must should not loosen its bailout programme, Spain can restore confidence with a bank recap plan that builds in a large margin for error and dismissing calls for the ESM rescue fund, which comes into being next week, to get a banking licence so it could draw on virtually unlimited ECB funds. That all sounds fairly uncompromising.

The G20 summit may have marginally exceeded the lowest common denominator of expectations with euro zone leaders pledging to work on integration of their banking sectors as part of a push towards fiscal union. But it’s not clear that a banking union will happen any quicker than we thought before.

Germany is happy for cross-border oversight, maybe in the hands of the European Central Bank, to be zipped through but on the really vital parts of the structure – particularly a deposit guarantee scheme to guard against bank runs – it has clearly said it would only be possible once the drive towards fiscal union is set in stone. It will also not countenance mutual debt issuance until the fiscal union is in place.

Onus was put on next week’s EU summit to put flesh on the bones, although no definitive decisions are expected there and EU Commision President Barroso he would present its plan on banking integration in September. Here’s the reality check: European Council President Van Rompuy spelled out the vision of a much deeper economic union to underline the irreversibility of the euro project and said it would take less than the 10 years that ECB chief Draghi has talked about. And for many countries, particularly France, the surrender of that much sovereignty will be very hard to take.

Things are on the move in Spain although nothing is set in stone yet.
Treasury minister Montoro’s call yesterday for “European mechanisms” to be involved in the recapitalization of Spain’s debt-laden banks – a reversal of Madrid’s previous insistence that it could sort its banks alone – unleashed a barrage of whispers in Europe’s corridors of powers.

Our sources say that the independent of audit of Spanish banks’ capital needs, the first phase of which is due by the end of the month, will be a key moment after which things could move quickly.

The hitch is that Madrid still doesn’t want the humiliation of asking for a bailout and Germany will not countenance the bloc’s rescue funds lending to banks direct. One possible solution floated last night –  the EFSF or ESM bailout funds could lend to Spain’s FROB bank rescue fund, which could be viewed as tantamount to lending to the state but would give the government some political cover to say it wasn’t asking for the money. This is anything but a done deal and there would still be some strings attached which could be tough for Prime Mininster Mariano Rajoy to swallow.

Greece is stumbling inexorably towards fresh elections which polls suggest will give the anti-bailout far left a stronger grip on power. Last ditch talks aimed at creating a unity government will continue under the aegis of the president today but the leader of the radical leftist SYRIZA has said he will not turn up. Alexis Tsipras says he wants Greece to stay in the euro but will rip up the bailout agreement. Go figure.
This morning the more moderate left party has said it won’t take part in a government lacking SYRIZA.

A big question is whether the mainstream parties can mount a convincing campaign second time around, playing on the glaring contradiction in SYRIZA’s position and essentially turning the vote into a referendum on euro membership, which the overwhelming majority of Greeks still support. Don’t count on that.

Two ECB policymakers –  Honohan and Coene – were out over the weekend talking about the possibility of a Greek euro exit: there goes another taboo. Policymakers must be running through the hard default and exit scenarios now. We need to be asking.

With hundreds of billions worth of stimulus measures set to expire on Jan. 1, investors are all too aware that the United States is hurtling toward what economists are calling “a fiscal cliff.” It’s just that most seem to think Congress will execute one of its typical last-minute, hairpin turns to avoid plunging the economy over the edge.

As Russ Koesterich, global chief investment strategist at iShares told Reuters recently, “people are worried but they feel some sort of fix will get done.” Certainly the equity and bond markets back him up: the S&P 500 is up a healthy 12.7 percent this year while benchmark 10-year Treasury yields remain pinned beneath 2 percent.

Ethan Harris at Bank of America-Merrill Lynch isn’t so sure. After all, we’re talking about the same group of politicians who nearly forced the United States to default last year and earned it a credit downgrade from S&P in the process. This time, Republicans and Democrats will have just seven weeks to stitch up a deal, and they’ll have to do it while the wounds inflicted by a brutally negative a presidential election campaign are still fresh.

Judging by the heated political rhetoric, you would think there is a great divide in America over the proper role of government. The drama is played out in battles over budgetary policy where one side wants low taxes and small government, and the other favors taxing the rich to pay for government programs.

Interestingly Americans, when faced with making the tough fiscal choices themselves, are remarkably pragmatic.

The Committee for a Responsible Budget since 2010 has invited people to go to its website and figure out how they would cut the U.S. budget debt load, which is fast approaching 100 percent of GDP. They must make specific choices, such as whether to cut farm subsidies or Social Security payments and what tax rates to impose.