Budget deal gets done and everything fal

The US Congress and Senate finally came to a compromise and passed a bill that increased the debt limit and allowed the US government to continue paying its bills. Why then are equity prices and the Canadian dollar all falling?

The increase in the debt came at a cost. The budget must be cut by $ 2 trillion over the next 10 years. (See a CNN article for details of the deal) That restriction will prevent the government from using discretionary fiscal policy as a tool to stimulate the US economy. With interest rates as low as they can go, the US has no room for expansionary monetary policy either. Since the US dollar is the world’s numeraire currency (the currency against which all others are measured), they have no exchange policy. None of this would be a problem except that it appears the US economy is headed for a recession. (See the Globe and Mail article). It would be a recession that the government cannot fight.

The deal also means that transfer payments from the federal government to the states will be reduced, thereby further straining their budgets. Forty-nine of the fifty states are required to have balanced budgets, so the reduction in transfers must be met by an equivalent reduction in state government spending. Those cuts reduce aggregate demand and further weaken the economy.

Any reduction in the US economy will result in a decrease in their imports. Since the US is Canada’s largest trading partner, our exports will fall. Aggregate spending in Canada is curtailed and that will slow the rate of economic growth here. The reduction in our exports also causes a reduction in the demand for the Canadian dollar which is why the loonie has fallen from its recent highs. (See the Bloomberg article)

The problems in the US have caused investors to reduce their holdings of US dollars, preferring instead the relative safety of gold and the Swiss Franc. We have recently seen record highs for both. The rise in the Swiss Franc has been dramatic enough to cause a decline in that country’s economic growth. To combat this, the central bank in Switzerland has recently reduced their interest rate to 0.25% and has initiated their own version of quantitative easing. The foreign exchange markets are now awash in Francs as the central bank forces down the exchange rate. (See Bloomberg article)

We will be watching the continued fallout from the political situation in Washington and try and keep you informed as the impacts are felt around the globe.