Why Obama's economic policy is repeating Napoleon's mistakes

The learning point from Napoleon’s folly is that if you confine and content yourself with what you know, the world will move on and leave you behind. In the world of economics there is a parallel today; the difference between the US and European responses to our economic malaise. The US continues to repeat its mistakes whilst the Europeans (the UK included) appear to have grasped the situation more fully and amended their behaviour, embracing deficit reduction.

Nothing could have illustrated this more clearly than the sight of the UK prime minister standing shoulder to shoulder with the US president in Washington recently, the former extolling the virtues of balancing the books and the latter denying it. Like Napoleon, the US appears consigned to the idea that it will continue to repeat its behaviour until it becomes its weakest link.

The US Federal Reserve, in a response to the idea of continuing the giveaway mentality, has said that it will recycle into US Treasuries the money it receives from the bombed-out mortgage assets it bought during the banking bail-out. Estimates vary as to exactly how much money we are talking about here, but something between $100 billion and $200 billion seems fair. If the Federal Reserve were to start buying long-dated bonds with that kind of money it could easily mop up the entire supply of newly-issued debt. At a time when equities are in scant demand and bonds are desirable, it creates the possibility of a collision between supply and demand that will have the required effect; bond yields will decline towards Japanese-style levels in the foreseeable future.

It is an inescapable point that when short term interest rates are so low, manipulating interest rates down via an extension or perpetuation of quantitative easing is the only course of action if you want to reduce the cost of borrowing for corporations.

We have used the notion of the output gap (the difference between potential and actual economic growth) and coupled it with the so-called Taylor Rule to calculate the appropriate interest rate to illustrate the redundancy of short term interest rate policy. Although we will extend this to other economies in the future, the US remains the main driver of the world and it is obvious that, in theoretical terms at least, the US would require severely negative interest rates under current growth assumptions. In that sense, the Federal Reserve is modern and adapting to circumstances by concentrating on reducing long term interest rates, while Obama, by extolling continued expenditure, is Napoleonic and repeating an experience over and over again.

The consequence of this ideological stand-off is that nothing much will change in the US - they will keep on spending other people’s money and printing unwanted US dollars. We should expect a couple of results from this. The US Federal Reserve will extend QE even further, whilst the ratings agencies will be sharpening their knives to deliver a credit rating blow into the back of the US, paralleling the end of another despotic leader and prompting cries of “Et tu, Moody’s?”.

There is also going to be a funding crisis; in the next few years close to 50% of all the outstanding US Treasury debt will mature, requiring it to refinanced. The year 2013 is particularly bad with over a trillion dollars set to roll off. In that sense, the best course of action is to over-stimulate the economy by manipulating long term interest rates down and allowing the dollar to decline against the world’s currencies.

Stewart Cowley is head of fixed income at Old Mutual Asset Managers and manages the Old Mutual Global Bond fund.