Global Trends by Martin Khor
Monday 18 July 2011
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.
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
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
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
Thirdly, the uncertainties in Washington
emphasise the present unhealthy dependence on the US dollar as the international
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
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
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.
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