The political deadlock in Washington on whether and how to increase the United States’ debt limit is causing anxiety over a possible default and the consequent global economic downturn.A Chinese 100 yuan banknote is placed under a $100 banknote. (Petar Kujundzic/Courtesy Reuters
THE deepening of the
Eurozone debt crisis last week through contagion, spreading to Italy, was more than matched by the growing chance that the US government would not be able to pay its bills or service its debts starting Aug 2.
Week-long negotiations took place between US
President Barack Obama, and the
Democrat and
Republican party leaders to avert a partial closing down of the federal government.
The US currently has a limit to its federal debt of US$14.29tril. This limit will be reached by Aug 2.
Congress has to approve raising this limit before then, or else the Administration will have to postpone meeting some of its financial commitments.
Federal Reserve chairman Ben Bernanke warned that default would send shockwaves throughout the global economy.
The alarm bells rang even louder when two rating agencies, Moody’s and Standard and Poor, warned they might downgrade
US debt from its AAA status if the political impasse continues.
There are several reasons why the world, and especially the developing countries, should be alarmed at this situation.
First, many developing countries hold many billions of dollars of
US Treasury bills as part of their foreign reserves.
An actual default raises the unthinkable prospect of the countries having to take a haircut, being only paid back a part of their bonds. This is unlikely to happen.
But even the prospect of default and a credit status downgrade would reduce the value of their bonds. Moreover the recent decline of the dollar’s value will likely accelerate, causing further losses.
Last week, China (which holds US$1.15tril in Treasury bonds) called on the
United States to adopt responsible policies and measures to protect investors of US bonds.
Second, economic growth in the developing economies will be hit if the standoff or the eventual solution causes the US economy to move to a standstill or a new recession.
Whatever the final deal between the President and the two Parties, its centrepiece is certain to be deep cuts in government spending. This will reduce effective demand in the economy.
The effect will be opposite to the Obama administration’s recession-busting fiscal stimulus that enabled the economy to bounce back after the 2008-09 recession.
Third, the uncertainties in Washington emphasise the present unhealthy dependence on the US dollar as the international reserve currency.
The need for reform to reduce this dependence on a single currency, for example, by greater use of the special drawing rights (a basket of major currencies) as a
global reserve currency, has been advocated by several prominent economists such as Joseph Stiglitz, Jose Antonio Ocampo and Yilmaz Akyuz as well as policy makers such as the Governor of the
Chinese Central Bank.
A default in servicing US debt has moved from the unthinkable to the possible, though still in the realm of most unlikely. It may reignite the debate on reform of the global reserve system.
The facts of the impasse in Washington are as follows.
The current debt limit of US$14.29tril is forecast to be reached on Aug 2, so no new loans are allowed after that.
The administration estimates that the debt limit has to be increased by US$2.4tril so that the government can meet its commitments up to November 2012, after the Presidential elections.
Many Republicans in Congress, especially those under the influence of the Tea Party group, want the government to achieve budget balance through slashing spending without any increase in taxes, and to achieve budget balance.
A few Republican leaders, however, are willing to consider a small increase in taxes, or rather in closing tax loopholes, but they are finding difficulty in convincing their colleagues. They also want spending cuts to exceed the rise in the debt limit.
The President and Democrats are willing to cut spending significantly, but want also to raise taxes of the rich, so that both can contribute to the deficit reduction.
Democrat leaders are adamant that social and medical security should not be affected by the cuts, though Obama is willing to allow some cuts there as well.
If the extreme stance of the Tea Party faction becomes the overall Republican line as well, a deal would be extremely difficult.
To meet it, the Democrats and President would have to move their compromise position to the degree of total capitulation.
If the deadlock continues, a possible solution may be the proposal of Senate Minority Leader
Mitch McConnell: the president submits his plan to increase the debt limit and to cut the budget, the Congress rejects it, the President vetoes the rejection, and his proposal is adopted unless two-thirds of Congress rejects it again.
This will allows all sides to claim that they stuck to their positions, while avoiding a crisis.
If there is still no agreement by Aug 2, then the administration will have to choose which items not to pay and when.
These include interest on Treasury bills, social security, medicare, defence vendors, unemployment benefits, food stamps, military pay, federal salaries.
Priority will be given to debt servicing, so a default on Treasuries is very unlikely unless the impasse lasts a long time.
The other services and salaries will be hit, and increasingly so as long as there is no deal.
As almost everyone will agree, this is no way to run a government, and the US governance system is becoming dysfunctional.
This has serious effects on the rest of the world. So the universal hope is that some solution will be found before Aug 2.
Global Unease on U.S. Debt Impasse
| By Jonathan Masters, Associate Staff Writer |
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With the deadline for a U.S. credit default less than three weeks away, President Barack Obama and top Republican lawmakers remain at odds over a deficit reduction plan that both sides view as a prerequisite to any hike in the debt limit. The impasse continues to fuel apprehension within the global financial system, with two of the "Big Three" credit rating agencies--Moody's and Standard and Poor's--considering
downgrading the United States (WSJ) from its AAA status.
Moody's cited the "rising possibility" the U.S. debt limit will not be raised in time to avoid default. Economists warn that a significant loss of confidence in the U.S. debt market could prompt foreign creditors to unload large portions of their holdings, sparking a sharp increase in U.S. borrowing costs and calling into question the dollar's role as the world's reserve currency.
Most economists agree that the impact of an outright
government default would be severe. Federal Reserve Chairman Benjamin Bernanke has warned a default would usher in a new financial crisis. While some suggest the market still assumes the issue will be resolved, they say a default would do unprecedented injury to the full faith and credit of the United States and
roil international markets (DowJones) in a sea of uncertainty.
China, the largest U.S. creditor, has reiterated its call for a swift compromise in the debt talks. Beijing would be particularly exposed to any acute shock to the bond market, with about 70 percent of its $3.2 trillion foreign exchange reserves invested in
U.S. Treasuries (Reuters). Historically, the U.S. debt market has been driven by huge investments from surplus countries like China, which have viewed the United States as the safest place to store their savings.
The
Economist notes that while a default may not precipitate an immediate sell-off by foreign banks due to a lack of immediate alternatives, the event would
discourage future holdings of such magnitude. As the largest economy and home to the world's reserve currency, the United States has traditionally attracted investors looking for a financial safe haven. But some analysts suggest the current fiscal crisis, including the threat of default, could accelerate a shift in the way
global capital is allocated (TIME)--away from developed nations like the United States and Japan and into emerging markets such as China and India. The
Wall Street Journal reports that in addition to China, investors in Japan, Russia, and a number of Persian Gulf states will increasingly look for
alternative investments to diversify their sovereign holdings.
Bill Gross of the investment management firm Pimco writes that global investment managers are keen to
punish defaulting countries (WashPost) severely, adding that alternatives like Canada and Germany are only a wire transfer away. He says a default may prompt foreign banks to rethink their currency preferences, jeopardizing the reserve status of the dollar. A 2010 survey by the McKinsey Global Institute found fewer than 20 percent of business executives surveyed expected the dollar to be the dominant
global reserve currency by 2025. However, with a systemic debt crisis racking Europe, some analysts claim there is still
no viable alternative to the dollar (DowJones) in the short to medium term.
But an impression of eroding U.S. power is already gaining traction. The latest
Pew Global Attitudes poll finds: "In fifteen of twenty-two nations, the balance of opinion is that China either will replace or already has replaced the United States as the world's leading superpower." The poll says the "United States is increasingly seen as trailing China economically."
Selected Analysis:The United States has entered its "own age of austerity," with the solution to country's
fiscal woes coming only through long-term spending reductions, particularly in entitlement programs, writes Mort Zuckerman in the
Financial Times.
A period of austerity brought on by debt mistakes will have "profound consequences, not just for Americans' standard of living but also for U.S. foreign policy and
the coming era of international relations," write CFR President Richard N. Haass and former Deputy Treasury Secretary Roger C. Altman in
Foreign Affairs.
This report from the Brookings Institution addresses the nature and quality of
U.S. political leadership, the sources of the nation's governance problems, and some strategies to work around them.
The New America Foundation's Maya MacGuineas recommends an immediate increase in the debt ceiling and the negotiation of
big budget deal ($4 trillion) that will keep the nation's debt from outpacing the economy.
Weigh in on this issue by emailing
CFR.org.
The Vatican said the talks between the two leaders had been "cordial" 
