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Global Power Shift Egypt Tip of the Iceberg View GEF Archive

		The Global Economics Team

			Stephen S. Roach
Stephen S. Roach is Managing Director and Chief Economist of Morgan Stanley.
			Serhan Cevik
Serhan Cevik is a Vice President who covers the Middle East and North Africa.
		Read about other GEF team members

This shift in political power is occurring at a unique juncture in the US economic cycle.  The profits share of national income currently stands at a 50-year high of 12.4% (see accompanying figure).  At the same time, the portion going to labor compensation is just 56.3% -- the lowest a newly elected Congress has faced since 1965.  In other words, the Democrats are assuming power at a point in time when the returns to capital are at historical highs and the rewards to labor are at more than 40-year lows.  This underscores the most profound economic implication of all: Just as the pendulum of political power has swung to the left in the United States, I think there is a very good chance that the pendulum of economic power could swing from capital back to labor in the years ahead.

Don’t look to the modern history of the American political cycle in attempting to discern the outcome.  The shift in congressional control that has just occurred -- with the Democrats retaking the leadership of both houses of Congress simultaneously -- last occurred back in 1955.  In the 25 years that followed, the Democrats maintained control of both the House and the Senate.  It wasn’t until the election of 1980 -- Ronald Reagan’s first term -- when the Senate went Republican for the first time since 1953.  And it wasn’t until the election of 1994 -- a stunning mid-term defeat for Bill Clinton -- when the House of Representatives went Republican for the first time since 1953.  Long the resident party in power insofar as Congressional control was concerned, it has been fully 54 years since the Democrats did what they did last November.  By simultaneously seizing control of both houses of the US legislature -- albeit with the narrowest of possible margins in the Senate -- modern-day Democrats find themselves essentially in uncharted waters.

That’s not to say politics haven’t mattered in shaping recent economic cycles in the US.  In looking at the past 40 years, the tug-of-war between capital and labor does appear to have been influenced by the party affiliation of the President.  Three of the most recent upsurges in the labor share of US national income occurred in Democratic Administrations: LBJ’s Great Society Program was key in pushing up the labor share in the late 1960s and early 1970s.  Similarly, there was a significant increase in the compensation share of national income in the final years of the Carter Administration in the late 1970s.  And the last time there was a meaningful gain in the labor share was in the late 1990s during the second Clinton term -- albeit in that case, the increase stopped well short of that which occurred in the Johnson and Carter Administrations. 

In this context, a White House that remains in Republican control appears to argue against a shift from capital to labor.  But it should be pointed out that in none of those earlier instances of Democratic leadership was the ascendancy of labor instantaneous -- typically there were lags of around 2-3 years.  Moreover, at no point in those earlier political cycles had the pendulum swung as far in a pro-capital direction as is the case at present.  In the end, it may well be that a weakened Bush presidency is in no position to stand in the way of forceful pro-labor initiatives from the new Democratically-controlled Congress. 

We’ll know soon enough.  Confirmation of a pro-labor shift should be evident in the early months of 2007.  Look for the new Congress to push ahead on several fronts:  The first hike in the minimum wage in 10 years is a “done deal” -- a two-year 40% increase from the current $5.15 per hour to $7.25.  Imminent tax hikes on the oil industry are also on the radar screen, as is focus on the excesses of executive compensation.  Moreover, an intensification of protectionist pressures is a distinct possibility, as the newly elected Congress views America’s gaping trade deficit as a threat to the job and income security of middle-class workers.  Despite Republican control of the White House, most of these initiatives could well be veto-proof in the current political climate.  And, most likely, they are just a down-payment on what is likely to be a multi-year pro-labor agenda of newly empowered Democrats. 

Of all these possible developments, the one that worries me the most is the mounting risks of protectionism -- especially the scapegoating of China.  Over the past couple of years, the so-called Schumer-Graham approach -- a proposed 27.5% tariff on all Chinese goods sold in the US -- has been the lightning rod in US-Sino trade tensions.  At the request of newly-appointed US Treasury Secretary Hank Paulson, the two senators withdrew their bill last fall; they were mindful that the draconian tariff proposal could not only deal a lethal blow to global trade but that it was probably not even WTO compliant.  Yet far from having given up, both Schumer and Graham appear more determined than ever to craft a different measure -- this time, joining forces with Senators Baucus and Grassley, the two leading members of the Senate Finance Committee.  Look for a new and important bipartisan proposal on trade coming jointly from these four senators in the first half of 2007. 

The intensification of anti-China sentiment in the Congress was fueled by three major developments in the aftermath of last November’s election -- a disappointing outcome of the mid-December US-Sino strategic dialogue in Beijing, inflammatory and mis-directed statements by Fed Chairman Ben Bernanke (see my 18 December dispatch, “Who’s Subsidizing Whom?”), and the latest foreign exchange report of the US Treasury, which disappointed congressional hard-liners by once again failing to charge China with currency manipulation.  Collectively, these developments seem to have instilled a newly-elected Congress with an even greater sense of determination to get tough on China.  An equally significant development on the protectionist front is that political leadership in the anti-China campaign could swing from the Senate to the House.  In fact, it is hard to identify a free-trade advocate in the House who is in a position to derail this increasingly fast-moving train. 

I have personally presented the counter case to the China blaming to so many politicians, I have lost count.  As a saving-short nation, America is biased toward chronically large deficits -- I remain convinced that our large bilateral imbalance with China is an outgrowth of a serious and worrisome saving deficiency.  A Congress that closes down trade with China -- or materially alters the terms on which this cross-border commerce is occurring -- runs the real risk of simply transferring the China piece of a gaping multilateral US trade deficit to another trading partner, imposing the functional equivalent of a tax hike on American consumers.  This is a lose-lose response to Congress’s growing frustrations with the win-win rubric of the globalization debate.  Logical or not, the point is that no one in the US Congress is listening to the other side of the debate.  That could well put Washington in the increasingly dangerous position of veering ever closer to the slippery slope of protectionism.  A move by China -- especially on the all-important intellectual property rights issue -- could go a long a way in defusing this tension.  But my latest discussions in Beijing do little to encourage me that anything is in the offing on this side of the debate either.

Courtesy of this sea change in the US political landscape, important changes are likely in the US economy and financial markets.  The stock market could be adversely affected by the negative earnings implications of a shift from a pro-capital to a pro-labor political climate.  The bond market could be hurt by perceived risks to inflation brought about by new pressures on labor costs in conjunction with the potential inflationary fall-out of mounting protectionist risks.  The US dollar could be hit by China’s diminished appetite for dollar-denominated assets -- a painfully logical response to Congressional intensification of China blaming. 

Nothing is forever.  The political and economic climate has been amazingly hospitable for financial markets for a long time.  But with this climate have come tensions and consequences that have sparked a powerful response from America’s body politic.  Therein lies the change agent: As is always the case when the pendulum of political power swings too far to one end of the spectrum, it is now starting to swing back the other way.  That puts the US Congress on a very different path than has been the case in a long time.  And it also suggests that the pendulum of economic power could well be starting to swing from capital back to labor.  Courtesy of this power shift, it’s as if the movie of the past six years is about to run in reverse.

Egypt
Tip of the Iceberg
January 09, 2007

By Serhan Cevik | London

The rise in consumer price inflation is just the tip of a greater threat, in our view. According to the latest official figures, the consumer price index increased at an annual rate of 12.2% in November, up sharply from 3.2% at the end of 2005. Although the sudden rise in inflation is partly a result of one-off factors (such as the reduction in fuel subsidies and a supply shock in meat prices) that should gradually ease in the coming months, we must not overlook the role of macroeconomic imbalances in shaping the behaviour of inflation. In our view, loose monetary and fiscal policies are the real reason behind overheating of the economy and the resulting shift in underlying inflation (see The Dangers of Overheating, December 14, 2004). Unfortunately, we believe that the Central Bank of Egypt’s response so far — a 75bp increase in overnight deposit and lending rates — is not enough to correct negative real interest rates, curb demand pressures in the economy and bring inflation within the ‘price stability’ range. However, even though further tightening of the monetary policy stance is necessary, in our view, it would not deal with the underlying source of inflation — fiscal imbalances.

The extent of fiscal correction is inadequate to address fundamental weaknesses. Above-trend growth, soaring privatization revenues and the settlement of tax arrears helped to lower the general government budget deficit from 9.1% of GDP in the 2005 fiscal year to 8.6% in 2006. This may sound encouraging, but we believe that the extent and composition of fiscal correction is insufficient to address structural problems in the public sector. Even with the gradual reduction in fuel subsidies, government expenditures kept growing from 30.5% of GDP in 2003 to 33.5% last year. As a result, despite strong economic growth, the primary budget balance, excluding interest payments, stood at 3.3% of GDP. This is why the government’s proposal to reduce the overall budget deficit by 1 percentage point a year is not enough to improve debt dynamics and support the central bank’s ambitious plan to adopt inflation targeting, in our view.

Net public debt increased from 47.4% of GDP in 2000 to 70.5% last year. One of the best measures of credit quality and sustainable growth is the debt/GDP ratio. Regrettably, Egypt has a disappointing score on this front, with the marked increase in net public debt from 47.4% in 2000 to 70.5% last year. However, our concern is not just about debt dynamics over the longer term, but also the inflationary impact of fiscal imbalances. The recent adjustment in administered prices is a case in point. Since government subsidies are still at a highly distortionary level, the economy is likely to remain exposed to adjustment costs for the foreseeable future. Furthermore, the extent of monetary financing of the budget deficit remains at an unsustainable level. The central bank’s monetary claims on the public sector expanded by 66.1% since 2001, albeit the rate of increase slowing to 4.4% in the last fiscal year. In other words, the central bank still carries almost half of the country’s outstanding debt stock — an unprecedented degree of fiscal dominance that threatens economic and financial stability (see The Burden of Fiscal Dominance, October 12, 2005).

Achieving sustainable growth requires fiscal and monetary tightening. Egypt has a noteworthy potential to maintain welfare-enhancing economic growth, but achieving that on a sustainable basis requires, above all, fiscal consolidation, independent monetary policymaking and a truly flexible exchange rate regime. Unfortunately, despite some encouraging steps in the right direction, today’s policy framework is still nowhere near what the Egyptian economy actually needs, in our view. Indeed, although the authorities have tried to improve the business climate by reducing bureaucratic costs and the tax burden, the current blend of fiscal imbalances and negative real interest rates keeps contributing to unbalanced growth and higher inflation. In our opinion, the government’s reform strategy is just too slow to bring the necessary adjustment in time. And without significant fiscal correction — that is, running a primary budget surplus — at a sufficient level to ease fiscal dominance, we believe that Egypt’s economy and financial system will remain vulnerable to underlying risks and exogenous shocks.

 

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