Global Trends by Martin Khor

Monday 18 July 2011

US debt impasse worries the world

The political deadlock in Washington on whether and how to increase the United States’ debt limit is causing anxiety over a possible default and over a new global economic downturn.

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The deepening of the Eurozone debt crisis last week through contagion spreading to Italy was more than matched by the growing chance that the United States government would not be able to pay its bills or service its debts starting 2 August.

Week-long negotiations took place between the US President, and the Democrat and Republican party leaders to avert a partial closing down of the federal government.

The US presently has a limit to its federal debt of $14.29 trillion. This limit will be reached by 2 August.  Congress has to approve raising this limit before then, or else the Administration will have to postpone meeting some of its financial commitments.

The 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” or 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 $1.15 trillion in Treasury bonds) called on the US 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 centerpiece 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 2008-2009 recession.

Thirdly, 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, JoseAntonio 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 $14.29 trillion is forecast to be reached on August 2, so no new loans are allowed after that.

The administration estimates that the debt limit has to be increased by $2.4 trillion 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 in which 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 2 August, 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 2 August.