Economic Trends – June 30, 2011

Economic Environment

THE WORLD

Although the state of Western countries' public finances troubled us somewhat during the past quarter, we now feel that there is a high probability that the next global crisis will stem from the inability of governments to fulfil their financial obligations. Current debt levels are worrying and the spectre of a second global recession, just two years after the last one ended, could considerably worsen the situation.

The first country to fall will likely be Greece, whose parliament recently voted in an ambitious medium-term austerity plan. That said, the country will never be able to repay its current debts, which represent 150% of GDP and could reach 160% by year's end, despite tax increases of close to 7% of GDP. Although some private European banks committed, without guarantees, to renewing a portion of their loans maturing over the next year, investors are now turning their backs on Greek securities. This means the Greek deficit can now only be financed through the €85 billion or so joint rescue plan put together by the International Monetary Fund (IMF) and the European Union (EU). This band-aid solution will allow the can to be kicked down the road, without accomplishing much else. For one, Greek industries will not become more competitive as a result of this aid and, without the possibility of devaluing the currency, the government cannot do much to help them. Furthermore, Greece's debt level is now so high, that it will be impossible to return to sustainable levels. Even after €50 billion in expected asset sales (20% of GDP) during the coming four years (one of the conditions made by the IMF and the EU), Greece's debt service will remain very high—at best 5% of GDP per year. Thus the longer the government waits to reach an agreement with its creditors, the harder the landing will be, and the more the public, and not private industry, will take the hit.

We should not, however, think that Greece and the other peripheral European countries (Spain, Portugal, Ireland and Italy) are the only economies with unhealthy public finances. Right now, the United States is being closely watched by credit agencies and investors who could raise doubts about the quality of U.S. debt if the Treasury Department fails to pay up on the $30 billion in obligations maturing on August 4. This is a critical date, because it will be the first maturity date following the vote to adopt special measures that enabled the U.S. government to exceed its $14,300 billion debt ceiling (which is slightly less than 100% of U.S. GDP). Since 1960, the U.S. debt ceiling has been raised more than 70 times; however, the approaching 2012 elections are making it harder to get bipartisan initiatives through Congress. The Standard & Poor's (S&P) rating agency has indicated that a default on the August T-bills would result in an immediate downgrade of Treasury credit. However the agency, which placed the U.S. debt on credit watch on April 18th, remains mostly concerned about the government's ability to reduce its deficit over the next two years.

As for economic performance, Canada and the United States continued to grow during the first quarter of 2011 (+3.9% and +1.9% respectively) while Germany's growth accelerated to 6.1% and Japan slipped into a second technical recession with a 3.5% contraction. China's growth stabilized at 9.7%¹ during the first quarter.

The North American economy

THE UNITED STATES

After a respite at the start of the year, job creation slowed during the second quarter with the jobless rate hitting 9.1% during May. We note, however, that private sector jobs were created. This is a positive indicator of a U.S. recovery setting in, and is good news for the budgets of various levels of governments.

As mentioned, the U.S. public debt has been growing steadily since 2007. Total U.S. public debt, including all levels of government combined, now totals close to $100,000 per U.S. worker, compared with $60,000 in 2007. A good part of the increase is linked to governments' roles as stabilizing forces in the economy. During the recession, several investment and job creation programs, as well as fiscal easing initiatives, were put in place in order to smooth over the economic cycle. By passing the job creation torch over to the private sector, the public sector will be able to reduce its expenses while simultaneously raising revenues.

For the federal government, controlling its deficit during the second half of 2011 will be especially important, since the Fed will be slowing its purchases of Treasury securities. In fact, the Fed's bond purchasing program (QE2) ended in June. This program enabled the central bank to buy up about $600 billion worth of new securities while at the same time reinvesting the interest from the previous program (QE1). This has more than entirely financed the U.S. deficit since December.

CANADA

The Conservative Party now benefits from a majority position, opposed almost entirely by the NDP, a young party, in many ways not yet fully experienced in political gamesmanship. In four years, this freedom could well hurt the Harper government, which made generous promises to get elected on May 2. For example, if Finance Minister Jim Flaherty does not succeed in balancing his budget by 2015, he will have no one other than his own government to blame.

The strong job creation numbers that Canada has seen since the start of the year (+163k) coupled with steady GDP growth and inflation just slightly over the central bank's upper limit, enable us to affirm that the new economic cycle has in fact gotten under way. It is at this point that the Bank of Canada generally starts to raise its key rate.

The Canadian national accounts data also look good. For example, total Canadian public debt is $80,000 per worker, up about $20,000 since 2007. Adjusted for inflation, real public debt per worker is practically at the same level it was in 1995. That said, the indebtedness of Canadian households is starting to worry Bank of Canada Governor Mark Carney. At the start of the current quarter, Canadian households had debts worth close to 150% of their annual disposable income. By raising its key rate, the BoC could slow the pace, or even reduce the use of credit by households, though at the cost of some personal bankruptcies. The longer the BoC maintains its accommodative monetary policy, the more households will slip into default when the inevitable interest rate increases come. In the meantime, only the Canadian dollar's relative strength (C$0.963 for US$1.00) prevents the BoC from acting.


¹ GDP growth rates are expressed as annualized quarterly variations for all countries except China, whose GDP is expressed as annual variation.

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