It's the politics, stupid!

Aug 17, 2011

By Nayan Chanda

SOMETHING funny happened on the road to the market crash of Aug 8. As the markets opened for trading, investors rushed into the burning building they were supposed to flee.

Only three days earlier, rating agency Standard & Poor's (S&P) had spooked the market by downgrading the debt of the United States a notch from its long-held AAA rating. In a normal situation, you would expect punters to flee from the downgraded instruments to ones rated as more secure. Instead, the opposite happened. Investors dumped their equities and rushed into US Treasuries in droves - the very instrument whose downgrading had sparked the market rout. As a result, interest rates on Treasuries dropped to their lowest point since January 2009.

In this paradox lies the clue to the global crisis now. It is not so much the fundamentals of the US economy that have unnerved the market but rather deep scepticism of the politicians in charge.

Washington remains the safest port in a storm even though policy gridlock threatens a double-dip recession. The euro zone, the world's other go-to market, might have offered an alternative in earlier times. But today, the fundamental weakness of the euro and the continent's political division and fiscal ineptness have made it ground zero of the crisis.

Belated intervention by the European Central Bank (ECB) to shore up Italian and Spanish debt has only underscored the existential crisis of the euro. The piecemeal Band-Aid solutions offered by the European Union (EU) for its debt crisis, which has been building up for almost two years, have already exposed the basic flaw of the euro zone arrangement. Namely, poorer members have a credit card with the high borrowing ceiling of richer members.

Now that the results of the borrowing binge are hitting home, leaders fearful of their domestic constituencies are unable to take robust and decisive action. The strongest member, Germany, needs to pump in vast amounts of cash to save Italy and Spain - and eventually the euro - but that might be political suicide in the run-up to elections. The scene is dismal all around, with scandal-tainted politicians lacking the courage and authority to take tough measures to assure the market.

As if the woeful absence of political courage and cohesion is not enough to discourage investors, the EU's bureaucrats must surely win the gold medal for fecklessness. After congratulating themselves on agreeing to a bailout package for Greece on July 21, they left the small matter of formalisation until September, presumably when officials would return from the beach.

Rising yields of Italian bonds (the country is the world's third-largest debtor) went unnoticed until panic set in among investors fearing Italy's inability to service its debts. A sharp letter from European Commission president Jose Manuel Barroso raising the alarm finally brought officials back from their vacations and the ECB back to the task of salvaging Italian and Spanish bonds. Unsurprisingly, none of these belated actions has calmed investors' nerves.

Across the Atlantic, the US Congress too had taken off for its summer recess after weeks of hand-to-hand combat over the debt-ceiling debate. When the S&P downgrade was announced, Republican and Democrat leaders interrupted their vacations to go on television to blame one another for this blow to US prestige. Through their petty bickering, these officials fulfilled one of the justifications that S&P had offered for its downgrade.

The agency did not believe the Republicans - hell-bent on resisting tax increases for the rich - and Democrats, determined to protect social benefits and health care for the poor and the elderly, were capable of reaching a compromise that would pave the way to trim the large and growing debt. S&P knows that, compared with other developed countries, the US is still on much safer territory. The debt/gross domestic product ratio is projected to reach 85 per cent in a decade, and as the issuer of the reserve currency of choice, it has greater means of avoiding a default than any other country.

While the coming pain will be long and acute, the US, with its deep capital markets, entrepreneurial spirit, innovativeness and high productivity, retains the ability to ride out the current crisis.

'Americans can always be counted on to do the right thing,' Winston Churchill once said, 'after they have exhausted all other possibilities!' Unfortunately, the markets do not wait around for the dawn of political reality.

The writer is director of publications at the Yale Centre for the Study of Globalisation.