We must fix the broken Western state model

What will be the hottest topic at this week’s World Economic Forum in Davos? The Algerian hostage crisis or the global “bonds-into-equities” swap? The latest horrors from Syria or the prospects of a British EU exit?

There will be heated debates aplenty when the annual Swiss mountain gab-fest convenes on Thursday, on a head-spinning array of topics. It strikes me, though, that year after year, there’s one overarching issue that simply won’t go away.

When the world’s political and business elite gather for “Davos 2013”, the discussion will no doubt range from terrorism to quantitative easing, from biofuels to the rise of the emerging giants of the East. What the touchstone theme should be, though, is “the role of the Western state”. For the Western model is broken. Surely – that’s now impossible to ignore.

At the turn of the year, global markets held their breath as US lawmakers negotiated themselves away from the “fiscal cliff”. On that occasion, the White House was able to force Republicans into opting for higher taxes on the wealthy, in order to avoid tax rises for all. When it comes to the debt ceiling, though, which relates to the spending side of the balance sheet, opposition politicians have the upper hand. And it seems the Republicans are determined to extract revenge.

On 31st December 2012, at the height of the “fiscal cliff” drama, the US Treasury quietly announced that America had hit its $16,400bn national debt ceiling. So Congress must now approve, by law, any further rise in US borrowing – a process that used to be routine, but which has become increasingly vexed as America’s national debt has ballooned.

In truth, the world’s biggest economy has for some time had to borrow in order to meet the interest payments on its debts. So the extraordinary reality is that in recent weeks America has only avoided bankruptcy by relying on so-called “extraordinary measures” – accounting tricks, in other words, such as delaying the payment of tax rebates. Such a strategy cannot last. Unless Republicans agree to raise the debt ceiling, the US government will run out of cash some time between mid-February and early March.

During the “fiscal cliff” stand-off a few weeks ago, the danger was that America would be exposed, over a period of months and years, to a series of significant tax rises. Much was at stake, not least given concern on financial markets that higher taxation would undermine the fragile US recovery.

The debt ceiling, though, is much scarier, seeing as a “state shut-down” is possible, involving the non-payment of government bills and benefits, with all the social unrest that would cause. Even worse, a technical “US default”, were it to happen, would be nothing short of a body blow to financial markets, casting into doubt the safety of the world’s most widely-held financial instruments. So, US lawmakers, to say the very least, are playing with fire.

For now, Obama is refusing to negotiate, trying to call the opposition’s bluff. Congressional Republicans, meanwhile, are insisting that any increase in the debt ceiling must be matched by similar spending cuts over the forthcoming decade – the so-called “Boehner rule”, named after Republican House Speaker John Boehner. This is what happened during the debt-ceiling row in 2011 when, at the eleventh hour, Congress granted another $2,100bn of fiscal headroom, in return for $2,400bn of spending cuts over the subsequent ten years.

Back in the early 1980s, America’s national debt was $908bn. By 1996, it had reaching $5,000bn, before soaring through $10,000bn in 2008, as the sub-prime crisis hit and the resulting recession slashed revenues and increased benefit spending. Now we’re at $16,400bn, and counting, with US state liabilities topping 102pc of GDP, up from 70pc just five years years ago.

Debt growth at that pace simply cannot be sustainable. That’s why, eighteen months ago, the rating agency Standard & Poor’s stripped America of its prized AAA credit rating, decrying “political brinkmanship” and citing fears that the country’s dysfunctional political system couldn’t deliver credible plans to cut the stock of government debt. “The differences between political parties have proven to be extraordinarily difficult to bridge,” said S&P at the time. If anything, with Republicans stung by Obama regaining the White House, the current stand-off looks worse.

America is far from alone. Most of the large “advanced economies” are drowning in debt – as we lose competitive and our populations age. Among the emerging markets and developing countries, national debt levels average around 30pc of GDP, according to the latest data from the International Monetary Fund. Across the G7, the figure is an incredible 124pc. As Western growth has slowed in recent years, and benefit-spending risen, spin-obsessed governments have taken the easy route and raised implicit and explicit borrowing, rather than daring to explain to their voters that demography and simple arithmetic require that Western states simply must spend less.

This is precisely what the Davos crowd should be focused on – as boldly stated by Paul Polman, the chief executive of consumer-good giant Unilever, in his extraordinary recent interview with my colleague Kamal Ahmed.

“Governments needs to get used to lower spending levels … individuals need to get used to lower pensions and welfare payments … and businesses need to get used to the costs that come with it and bear their part,” said Polman.

Leaders of huge conglomerates exercise extreme caution when making public statements. So when the likes of Polman start breaking ideological taboos, the Western political classes – still locked in their “growth versus austerity” neo-Keynesian parlour game – need to recognize that game is up.

“People are realizing in the West that our model is not a sustainable model,” Polman continued. “The dynamics have now completely shifted but politicians don’t want to explain that to people … vested interests take too big a share of voice”.

The theme of this year’s Davos gathering is “resilient dynamism”. To be sure, as the numerous attending CEOs will attest, the economic environment is tough. In my view, though, too much emphasis is placed on the negative impact of spending cuts on growth, and far too little on the disastrous potential implications – in term of potential creditor strikes and Congressional blow-ups – when spending gets wildly out of control.

In an important speech last week, a Federal Reserve official called John Williams made clear that uncertainty over the direction of US fiscal policy – not just on the debt-ceiling, but general taxation too – was holding back a US recovery. Williams cited a long-established ”index of policy uncertainty” that has just hit a 25-year high. When uncertainly rises, Fed research has made clear what every business leader knows: investment falls, and so does full-time employment fall. That brings slower growth and lower revenues, compounding the fiscal squeeze even more. Certainly, recent fiscal shenanigans in Congress have been accompanied by sharp falls in US business and consumer confidence, just as they were back in 2011.

On Friday, John Boehner announced a vote this week on a short-term debt ceiling hike – coupled with a requirement that unless Senate passes a budget, lawmakers in both chambers of Congress won’t be paid. So another debt-ceiling battle looms. US equity markets, meanwhile, have just seen their third consecutive weekly gain this year.

For now, the assumption is the politicians, somehow, will resolve the debt ceiling stand-off – and they probably will. If they take the brinkmanship too far, though, we could see another debt downgrade and a related market correction.

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