Follies with Consequences: The US Debt Default Dance
Self-inflicted wounds get you coming and going, especially when suffered in public. The fiscal follies last month of the US Congress over the federal government debt ceiling and budget sequester are more than simply embarrassing. They have damaged the US economic recovery, and they have done lasting damage to US financial stability and negotiating power. And the whole breakdown was completely avoidable in economic terms, which if anything increases the reputational damage.
There is no known other example of a solvent democracy flirting with default through sheer political stubbornness. While many democracies with fragmented party systems spend themselves into crashes – think of Italy in the 1970s or Argentina repeatedly – the crashes only came when they had run out of credit. On the fundamentals, the US government is perfectly capable of rolling over its debt at historically low interest rates, and the dollar remains strong. As many of us forecast, the federal deficit is shrinking rapidly on the basis of even the anemic economic recovery. So the debt to GDP ratio of the US is on a downwards trajectory.
Yet, a group of radical right-wing Republican members of the House of Representatives threatened to have the US technically default on its debt, and the Republican Congressional Leadership lost all party discipline. Worse, this totally voluntary disruption of the US economy and world markets is likely to recur at intervals until the composition of the House changes – unlikely in the midterm elections of 2014, more probably in the Presidential election year of 2016, but possibly likely to persist until the next census and redistricting is completed in 2022. The dysfunctionality of US fiscal policy has become on ongoing reality.
The direct costs of these follies are already substantial. The sequester of Federal spending due to inability to agree from earlier this summer took 0.75% off of a forecast 2.75% real GDP growth in 2013. The government shutdown of October cost another 0.3%. And the arbitrary manner of the cuts hit government functions in as backwards a fashion as possible, cutting public investment and high-impact services for the poor, maximizing their immediate damage.
The ongoing uncertainty about US fiscal decision-making, and the recurrent risk of a repeat, is now dragging down American corporate investment. Companies were already sitting on unprecedented amounts of cash, reluctant to take risks for a variety of reasons good and bad post-crisis. The fiscal follies have sharply diminished recovery of capital expenditure that was forecast for late 2013 and 2014, which will further limit growth both in the near term and of productivity in the long-term. For all the talk about uncertainty for businesses arising from Obamacare or Federal Reserve policies, the impact of ongoing fiscal policy volatility on foregone investment will be much higher.
Worse still, there is now priced in to global markets a default risk on US Treasuries, where there had been none. Whether this is permanent or merely lasting is unclear, but it is new ground. While small, perhaps 10 basis points (1/10th of 1%) on average at present, this risk premium represents a profound change. The majority of financial contracts that were written to treat US Treasuries as the ultimate safe collateral and means of settlement, now have to be redone to allow for some divergence between AAA assets and Treasuries, if only temporarily – and that imposes a need for long-term investors and counterparties to hedge which raises the cost of all transactions. And US taxpayers will be paying on average the amount of that premium more on all newly issued US government debt from now on.
The most overlooked and perhaps most lastingly harmful effect of the fiscal follies will be the severely diminished ability of US to conclude international economic negotiations. For the most part, the US government went into economic discussions, whether trade negotiations, G7 or G20 summits, or IMF debt program discussions, with three strong cards: the ability to set the initial agenda; the financial strength to hold the line when there were disputes; and the credible tactic of demanding a good deal lest Congress object. All of those attributes are now diminished. At the IMF-World Bank and G7 meetings a few weeks ago, the first agenda item was criticizing the US (deservedly) and nothing else got tackled. The Obama administration’s ambitious trade agenda of concluding Trans-Pacific and Trans-Atlantic partnerships is stalling because of negotiating partners (rightly) doubting the ability of the US government to Congressional approval.
Some adjustment of US economic dominance is inevitable, as the size and income level of the US shrinks relative to the rest of the world. An unintended acceleration of that long-run process though domestic political failure, however, serves no one’s interests – least of all the US. Yet, unquestionably this entirely self-inflicted wound is speeding up American decline as well as undermining economic recovery.
Self-inflicted wounds get you coming and going, especially when suffered in public. The fiscal follies last month of the US Congress over the federal government debt ceiling and budget sequester are more than simply embarrassing. They have damaged the US economic recovery, and they have done lasting damage to US financial stability and negotiating power. And the whole breakdown was completely avoidable in economic terms, which if anything increases the reputational damage.
There is no known other example of a solvent democracy flirting with default through sheer political stubbornness. While many democracies with fragmented party systems spend themselves into crashes – think of Italy in the 1970s or Argentina repeatedly – the crashes only came when they had run out of credit. On the fundamentals, the US government is perfectly capable of rolling over its debt at historically low interest rates, and the dollar remains strong. As many of us forecast, the federal deficit is shrinking rapidly on the basis of even the anemic economic recovery. So the debt to GDP ratio of the US is on a downwards trajectory.
Yet, a group of radical right-wing Republican members of the House of Representatives threatened to have the US technically default on its debt, and the Republican Congressional Leadership lost all party discipline. Worse, this totally voluntary disruption of the US economy and world markets is likely to recur at intervals until the composition of the House changes – unlikely in the midterm elections of 2014, more probably in the Presidential election year of 2016, but possibly likely to persist until the next census and redistricting is completed in 2022. The dysfunctionality of US fiscal policy has become on ongoing reality.
The direct costs of these follies are already substantial. The sequester of Federal spending due to inability to agree from earlier this summer took 0.75% off of a forecast 2.75% real GDP growth in 2013. The government shutdown of October cost another 0.3%. And the arbitrary manner of the cuts hit government functions in as backwards a fashion as possible, cutting public investment and high-impact services for the poor, maximizing their immediate damage.
The ongoing uncertainty about US fiscal decision-making, and the recurrent risk of a repeat, is now dragging down American corporate investment. Companies were already sitting on unprecedented amounts of cash, reluctant to take risks for a variety of reasons good and bad post-crisis. The fiscal follies have sharply diminished recovery of capital expenditure that was forecast for late 2013 and 2014, which will further limit growth both in the near term and of productivity in the long-term. For all the talk about uncertainty for businesses arising from Obamacare or Federal Reserve policies, the impact of ongoing fiscal policy volatility on foregone investment will be much higher.
Worse still, there is now priced in to global markets a default risk on US Treasuries, where there had been none. Whether this is permanent or merely lasting is unclear, but it is new ground. While small, perhaps 10 basis points (1/10th of 1%) on average at present, this risk premium represents a profound change. The majority of financial contracts that were written to treat US Treasuries as the ultimate safe collateral and means of settlement, now have to be redone to allow for some divergence between AAA assets and Treasuries, if only temporarily – and that imposes a need for long-term investors and counterparties to hedge which raises the cost of all transactions. And US taxpayers will be paying on average the amount of that premium more on all newly issued US government debt from now on.
The most overlooked and perhaps most lastingly harmful effect of the fiscal follies will be the severely diminished ability of US to conclude international economic negotiations. For the most part, the US government went into economic discussions, whether trade negotiations, G7 or G20 summits, or IMF debt program discussions, with three strong cards: the ability to set the initial agenda; the financial strength to hold the line when there were disputes; and the credible tactic of demanding a good deal lest Congress object. All of those attributes are now diminished. At the IMF-World Bank and G7 meetings a few weeks ago, the first agenda item was criticizing the US (deservedly) and nothing else got tackled. The Obama administration’s ambitious trade agenda of concluding Trans-Pacific and Trans-Atlantic partnerships is stalling because of negotiating partners (rightly) doubting the ability of the US government to Congressional approval.
Some adjustment of US economic dominance is inevitable, as the size and income level of the US shrinks relative to the rest of the world. An unintended acceleration of that long-run process though domestic political failure, however, serves no one’s interests – least of all the US. Yet, unquestionably this entirely self-inflicted wound is speeding up American decline as well as undermining economic recovery.
