Downgrade delivers a much-needed wake-up call

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AFTER months of agonising negotiations, the US Congress finally agreed to raise the debt ceiling last week. The world waited, but assumed all along that some sort of deal would be nutted out, lest the US look like a complete fool and pensioners, soldiers and public servants went without pay cheques.

But as the members of the Congress scampered off to their holiday homes, the ratings agency Standard & Poor's had a little surprise up its sleeve. It decided to downgrade US federal government debt from AAA to AA+ on the basis of the inadequacy of Congress's compact to reduce spending, or more accurately, reduce spending below the forward estimates.

The questions now are: What will be the consequences for the US economy? What will be the consequences for the world economy? And how will it affect the Australian economy?

Of course, one of the strange things about the S&P downgrade is that the US debt is denominated in US dollars. This makes the situation in the US different from a number of other countries with large government debt. In theory, the US authorities could, at least in part, inflate its way out of its debt problem, although such action does have unfortunate distributional consequences as well as affect economic efficiency.

But with the downgrade, interest rates in the US can be expected to rise at a time when the US economy continues to struggle. And notwithstanding the amazing plea of Christina Romer, first head of Obama's Council of Economic Advisers, that "it isn't too late to pass another, bigger stimulus now" (the first stimulus was not big enough, according to the good professor), there is little doubt there will need to be bigger spending cuts to accommodate this new world order.

To achieve this, serious consideration has to be given to reducing spending in the three big areas: defence, social security and health (Medicare-Medicaid). To be sure, slashing a program here and a program there may seem like sensible politics. But unless there are serious attempts to reduce spending in these areas, the debt ceiling will need to be raised over and over again, thus cementing the financial bind in which the US government finds itself.

Of course, some commentators may point out that the US government debt situation is not as bad as a number of other countries, including Japan, Greece and Ireland. But as a percentage of GDP, the US is now where it never has been (more than 100 per cent on one measure). And the US federal government has gone from being the epitome of small government to yet another example of big government in a relatively short space of time.

So what are the likely economic effects of this most recent development? The first thing to say is that there is an important distinction between the effect on the real economy and the financial market repercussions.

In the case of the US, the real economy is actually quite weak and in the short-term, the outlook is poor. Having said that, a truly credible strategy to consolidate the fiscal position could lead to improved economic conditions down the track, as the private sector regains the incentive to invest and expand. The underlying resilience and innovativeness of the US economy should not be underestimated.

In theory, the Australian economy should be little impacted save for the ripple effects of financial instability and falling share prices. The state of the Australian economy is now much more dependent on what happens in China than elsewhere in the world. China, in turn, is generating much of its growth internally rather than relying on exporting consumer goods to the US and other developed economies.

This does not mean that the Australian economy will be unaffected; indeed, the Reserve Bank has already downgraded its growth forecast for this financial year by a full percentage point. And confidence is a fragile thing, with present indications in Australia - of both consumer and business confidence - pointing to a marked loss of positive belief in the immediate economic outlook.

Much of this loss of confidence can be put down to the consequences of a multispeed economy. Always a challenge for policy-makers, it has nonetheless not been well managed by the federal government. Without flexibility and productivity growth in the slow-lane parts of the economy, the adjustment to the historically high terms of trade has been more costly than necessary.

Of course, for those more directly exposed to the financial markets - retirees and superannuation members close to retirement - the outlook is especially uncertain. The truth is most of our listed companies have reasonably strong balance sheets and the outlook for profit and earnings is generally satisfactory. The trouble is when financial markets get the wobbles, objective analysis is jettisoned in favour of fear and dread.

The one bright spot is that if the US government can truly get its financial house in order, other indebted governments may follow and from there, an extended period of strong world economic growth could ensue based on the inventiveness and energy of the private sector.