Markets volatile. Economy in the tank. Now what do we do?

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The Gazette, Wednesday, August 10, 2011

Never mind that Standard & Poor's was one of the credit-rating agencies that gave sub-prime mortgages an AAA rating back in the day before the U.S. housing bubble burst, which ultimately led to the financial crisis of 2008.

And never mind that S&P, according to the White House and U.S. Treasury Department, made a $2-trillion mathematical error in projecting the U.S. debt.

The fact remains that for the first time in history, the credit-worthiness of the United States has been downgraded from AAA to AA plus. Canada, along with Britain and France, is among 30 AAA rated countries.

Naturally, the market responded to this news on Monday by rushing into U.S. treasuries as a safe haven from the turmoil that roiled the stock market.

Markets also rushed into the U.S. dollar, as the world's safest currency. The loonie, recently trading at $1.06, fell to $1.01 on Monday. Oil, recently trading around $100 a barrel, was off over $5.50 on the day to just over $81.

On the stock market, it was ugly, really ugly. In New York, the Dow was down 634 points, a loss of 5.5 per cent in a single session. In Toronto, the TSX was down nearly 500 points, or four per cent. In a single day, the New York and Toronto markets lost $1.35 trillion in market capitalization, equivalent to the output of the Canadian economy for an entire year.

Over the last two weeks, the North American markets have fallen about 15 per cent, when a 10-per-cent correction is considered bear market territory.

Both Toronto and New York opened with a relief rally on Tuesday, but the volatility makes being in the market an extreme sport. Fear is back. Fear of another 2008. Fear of a double-dip recession.

This isn't about the S&P downgrade, but a concern about the larger fundamentals of the U.S. economy and its fiscal framework, to say nothing of the institutional gridlock in Washington, as we have just seen with the political soap opera over raising the U.S. debt ceiling.

It's also about the euro-zone crisis. It was one thing when the European Central Bank, the International Monetary Fund, along with France and Germany, were bailing out Greece, Portugal and Ireland. But Spain and Italy are major economies - Italy is a G7 country.

Sitting on his front porch in Whitby, Ont. on Father's Day, Finance Minister Jim Flaherty said two things kept him up at night - the U.S. economy and gridlock in Washington, and the European sovereign debt crisis.

Events have since proven that his concerns were not misplaced. In the U.S., economic growth was a sluggish 1.3 per cent in the second quarter. Unemployment dipped slightly from 9.2 to 9.1 per cent in July, while in Canada it dropped from 7.4 per cent to 7.2 per cent. Stated another way, the U.S. has an employment rate of 58 per cent of the population, while Canada's employment is 62 per cent.

And as Flaherty points out: "The U.S. political system is already in campaign mode for the next presidential cycle, with the prospect that nothing will get done until after the election."

Not that much is getting done anyway, which is why Congress has an 82-per-cent disapproval rating in a New York Times-CBS poll. Barack Obama's 11th-hour deal with Congress, raising the debt ceiling by $2.1 trillion over two years in return for equivalent spending cuts over a decade, just kicks the deficit and debt problems down the road past the election.

And here's where S&P got it right in their report, stating: "The political brinksmanship of recent months highlights what we see as America's governance and policy-making becoming less stable, less effective and less predictable . The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy."

The U.S. fiscal framework is scary, with the deficit of $1.6 trillion, 10 per cent of GDP, and a debt that has now crossed the previous threshold of $14.3 trillion. This is more than twice the debt level of when Bill Clinton left office only a decade ago, and while most of it occurred on the watch of George W. Bush, Obama now owns it all.

At a time when he needs more economic stimulus, he has no fiscal tools at his disposal. As for monetary policy, the Federal Reserve can't pump any more liquidity into the economy; interest rates are already at rock bottom. It could possibly announce another round of buying back bonds, as it did with the $600 billion of quantitative easing that ran out in June. The Fed was meeting Tuesday, and the markets were waiting for any encouraging word.

What now? The G7 finance ministers have been on the phone all week. Anybody want to be finance minster for a day? You would have to learn to duck.

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