AMERICAN.COM

One has to highly commend Standard and Poor’s for its brave decision this morning to disregard political pressure and to put the U.S. government’s AAA rating on negative watch for a downgrade. Its decision could not be a more timely warning to the United States of the very grave consequences of not soon coming up with a credible medium-term program to put the U.S. government’s finances on a sustainable path. It also could not be a more timely warning to both President Obama and Congress about the dangers of playing political football with the U.S. debt ceiling limit that, absent an upward revision, is due to be exceeded in early July.

One has to hope that S&P’s warning allows cooler heads to prevail on Capitol Hill in the present debt ceiling debate. At a minimum, one must hope agreement can soon be reached on a desired path of medium-term budget deficit reduction that would restore U.S. fiscal sustainability, and on a set of automatic spending cuts that would come into effect should those deficit targets be missed.

Europe’s recent difficult experience with its public finances would seem to offer the United States a cautionary lesson about the dangers of fiscal irresponsibility. In particular, U.S. policy makers should not take comfort from the fact that, despite its very poor public finances, the U.S. government can still finance itself at very low interest rates. As Greece, Ireland, and Portugal’s recent experience has highlighted, when markets finally do lose confidence in the sustainability of a government’s public finances they tend to do so abruptly. This tends to be highly disruptive to financial markets and tends to be associated with prolonged and deep economic recessions. It also places a government in a position where foreigners can dictate the terms of future lending that can be harmful to a country’s economic growth prospects.

Yesterday Mr. Trichet, the European Central Bank president, did nothing to enhance the ECB’s credibility in the markets regarding its ability to get ahead of the European sovereign debt crisis. After intimating earlier in the week that markets should not underestimate the resolve of the ECB to act, Mr. Trichet produced a mouse at the ECB’s monthly meeting. Instead of the shock and awe that the markets were led to expect, all that he could offer was a commitment not to exit from the ECB’s generous provision of bank liquidity for another three months and a promise to continue periphery bond purchases in the secondary market.

If there is one constant in the current sovereign debt crisis, it is the ECB’s penchant for remaining behind the policy curve and for operating in a strictly reactive mode. It only remains a matter of time before markets again test the ECB. And as the European sovereign debt crisis is allowed to spread to systemically more important countries like Spain and Italy, we are getting ever closer to the European Monetary Union’s final day of reckoning.

In deciding to reappoint Ben Bernanke as Federal Reserve chairman, President Obama is exercising the most selective of memories. Indeed, the president is choosing to remember only Bernanke’s valiant role over the past nine months in pulling the economy from the brink and in preventing the country’s worst economic and financial crisis in the postwar period from morphing into a second Great Depression. What the president is blithely choosing to forget, however, is the role that Bernanke might have played during his first two years as Fed Chairman in creating the very economic and financial conditions that got us into the mess in the first place.

At the very time that the Federal Reserve is going to need the most judicious of leaderships, President Obama is choosing to turn a blind eye to Bernanke’s all too many errors of judgment in 2006 and 2007. Among the matters that the president is choosing to forget is that it was on Bernanke’s watch as Fed chairman that the worst of the sub-prime mortgage lending was made and that the worst excesses of the housing market and credit market bubbles occurred, without as much as an expression of concern from the Fed. The president is also choosing to forget how slow Bernanke was to comprehend the seriousness of the bursting of the housing market bubble and how slow he was to begin cutting interest rates to provide much needed support to the economy.

Bernanke’s main challenge during his second term will be to prevent the Fed’s massive injection of liquidity into the financial system from leading to an unwelcome bout of inflation. Exiting from the Fed’ recent massive monetary policy easing will require the most careful exercise of judgment as to timing. If the Fed moves too soon to mop up liquidity and to raise interest rates, it will risk aborting the incipient economic recovery. If the Fed moves too little and too late, as seems more likely, it risks letting the inflation genie out of the bottle.

In a country of 300 million people, one would have thought that President Obama could have found someone other than Bernanke with his track record of poor judgment to lead the Fed at this delicate juncture. However, now that the president has made his decision, one can only hope that the gods smile favorably on Bernanke and that his second term in office proves decidedly more successful than his first.

This morning’s U.S. GDP numbers provide welcome new evidence that the worst postwar economic recession is finally drawing to a close. Indeed, they show that the U.S. economy’s annualized pace of decline decelerated sharply from 6.5 percent in the first quarter of 2009 to only 1 percent in the second quarter. However, before we break out the champagne, it is well to focus on one aspect of this morning’s numbers that strongly suggests that the U.S. economic recovery following the recession is more than likely to be unusually weak.

The most disturbing detail of this morning’s numbers is that they reveal that consumption demand, which accounts for around 70 percent of U.S. aggregate demand, declined by 1.2 percent in the second quarter of 2009, or at twice the pace that had been expected. And it did so despite the fact that U.S. household disposable income was substantially boosted on a one-off basis in the second quarter by tax cuts and Social Security payments under the Obama fiscal stimulus package.

The key question going forward must be what will happen to U.S. consumer demand when household incomes are no longer artificially boosted by the fiscal stimulus package as will already be the case in the third quarter of 2009. Might it not be reasonable to expect that U.S. consumption demand will continue to decline as households respond to the recession-induced decline in their wages and as households try to increase their savings in response to their reduced wealth? And if consumption does indeed stagnate, at best is there really much prospect for a meaningful recovery in 2010 that will make any dent in an unemployment rate that is now headed for double-digit numbers before year-end?

Ben Bernanke is now learning that serious policy mistakes at the Fed might have real long-run costs that could very well undermine the Fed’s effectiveness as an institution. For as the political backlash to the economic crisis mounts, a growing chorus of congressmen, from both the left and the right sides of the political spectrum, is clamoring for greater Fed oversight.

Congress’s demands for more Fed oversight are understandable. After all, the Federal Reserve is primarily responsible for having caused the housing and credit market bubbles in the first place through its excessively low interest rate policy and through choosing not to use its regulatory powers to limit sub-prime lending. The Federal Reserve was also all too slow in reacting to the bursting of those bubbles and it was less than transparent in its unprecedented financial market intervention to avert a total financial market meltdown as it more than doubled the size of its balance sheet to US$2 trillion.

Understandable as Congress’s rage with the Fed might be, one does not want the Fed to lose its monetary policy independence, especially at this delicate juncture. For such a loss of independence will prevent the Federal Reserve from aggressively raising interest rates in the years ahead to the levels that will be needed to stop the Obama budget profligacy from causing an inflationary burst once the U.S. economy finally fully recovers.

If a price should be paid for the Fed’s egregious mistakes over the past four years, it should be President Obama’s refusal to renew Mr. Bernanke’s term when it expires early next year. One also might want to think of calling for the replacement of Mr. Bernanke’s senior lieutenants who participated in his poor decisions.

Today’s decision by the S&P rating agency to place the United Kingdom government’s AAA rating on negative watch should be a wake up call to the Obama administration about the dangers of fiscal profligacy. So too should the Chinese government’s repeated comments about its reluctance to keep adding to its already extraordinarily large U.S. Treasury holdings, as well as the ¾ percentage point back-up in long-dated U.S. Treasury yields over the past 2 months.

S&P based its UK decision on the view that in the absence of early remedial action, the UK’s public debt-to-GDP ratio would remain at close to 100 percent over the medium term. This has to make one wonder what S&P must be thinking about the dangerous trajectory on which the Obama administration’s fiscal stimulus package and budget proposal is placing U.S. public finances. For according to the nonpartisan Congressional Budget Office, President Obama’s budget proposal would result in budget deficits of over US$1 trillion a year over the next 10 years. It would also result in the doubling of the U.S. public debt ratio from 41 percent in 2008 to 82 percent by 2019.

The risks that ever-increasing U.S. public debt levels raise for the long-run U.S. economic outlook are multiple. For not only do they raise the likelihood of a dollar crisis and a further substantial rise in long-term interest, they also heighten the likelihood of sustained inflationary pressures once the U.S. economy eventually recovers. These very real risks are almost certain to undermine the U.S. long-run growth potential.