On the economic consequences of the politics in the US, Germany and Europe

Today’s commentary

Summary: The German election and the US debt ceiling crisis are the two political events dominating the economic headlines – and for good reason; these two events could have potentially big consequences on the regional and global economy. In the case of the US, a threatened debt default would be catastrophic. Some comments on what to expect are below.

The US government is likely to shut down

First, let’s look at the US. As it stands now, we are at an impasse where a government shutdown seems likely. Republican Speaker of the House John Boehner has said Republicans are unlikely to support sending a clean debt ceiling bill without conditionality attached to the President. And the President has said he would not negotiate with the Republicans again over the debt ceiling issue. Given those negotiation stances, a shutdown is unavoidable. The question then is how long the respective parties are going to maintain their stance.

According to Mark Zandi of Moody’s a three-to-four week government shutdown would shave 1.4% off of annualized US GDP in Q4. This is not necessarily enough to send the US economy into recession but these are just the direct effects. There might be knock on effects in credit markets that lower GDP further. On the other hand, if the US defaults on its debt, it would be catastrophic for markets as US Treasuries serve a wide-ranging role as hedging instruments, collateral and reference bonds beyond their status as source of interest income. The disruption to markets would be widespread and severe. For this reason, many believe the US will eventually craft a deal – simply because it must to avoid this avoidable and catastrophic outcome.

As it stands now, a clear majority of Americans reject the Obama stance that only a ‘clean’ debt ceiling bill is reasonable. And while this may change after the government shuts down, the polls suggest that Republicans have a stronger negotiating position once the shutdown does begin. All of this is predictable because we knew when the last debt ceiling negotiations ended that the US was likely to hit the debt ceiling again before the year was over. And while I think the crisis will be resolved – or rather, the US will kick the can down the road a bit, a recession – even a deep one – cannot be ruled out. I should also note that the US is slowing down at the moment with Q3 growth likely to come in with a 1-handle instead of the 2.5% that the US recorded in Q2.

Germany (and Europe) is going to tilt left

The case I made in January about the German elections is indeed the one that we have been presented with. You have three coalition possibilities, CDU/CSU/SPD, CDU/CSU/Greens, SPD/Greens/Linke in declining order of probability. There is also the possibility that we will get entirely new elections too. While the German election was a victory for Merkel, the door is still open for the SPD to derail her. She is not master of her own destiny because she depends on a coalition with a left-leaning party. The SPD is easily the most natural of all the potential partners. 

The SPD will demand big concessions for a coalition with Merkel because if the SPD join Merkel without heavy concessions, they will lose voters on the left to the Greens and the Linke in regional elections. So, I expect the SPD to at least demand the finance ministry in return for grand coalition. Now let’s remember that Merkel rebuffed the Bundesbank in favour of the ECB on the OMT affair and she has ever since been in that camp. The ECB’s Jörg Asmussen might even welcome the change, especially one to the SPD since he is an SPD party member. The Grand Coalition looks very likely as SPD Chancellor contender Peer Steinbrück is leaving politics after his defeat to Merkel, paving the way for an easier negotiating path with the CDU. All of which is to say that Merkel is amenable to the leftward change.

What I am now hearing are two things: First, Merkel may be willing to raise taxes on the rich as a concession to her new coalition partner. That’s what Spanish site Cinco Dias is saying. Second, the FT is reporting that SPD head Gabriel is going to put a coalition to a referendum vote in order to make sure he has a free hand in negotiating with the CDU without sniping from the left wing of the party. The risk here is that the referendum fails and that makes the grand coalition impossible.

My view here is that, irrespective of what happens, the German governing positions on Europe are likely to keep up a leftward tilt. And that means backloaded austerity instead of front-loaded austerity, bailouts, ECB activism, and stimulus from Germany and via EU-wide structural funds. This is supportive of growth and means we are less likely to slip back into a European-wide recession in the near-to-medium term. The real question right now is about whether the periphery can take the stagnation that is part and parcel of the present policy mix. It is not off to the races for Europe. Problems – big ones – will remain whether Germany tilts toward stimulus or not.