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Debt Crisis Implications

Speakers: James M. Lindsay, Senior Vice President, Director of Studies, and Maurice R. Greenberg Chair, Council on Foreign Relations, and Sebastian Mallaby, Director, Greenberg Center for Geoeconomic Studies, and Senior Fellow for International Economics, Council on Foreign Relations
July 21, 2011

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JAMES LINDSAY:  Thank you.  Let me welcome all of you to this Council on Foreign Relations media conference call regarding the implications of the debt crisis.

My name is Jim Lindsay.  I am the director of studies here at the Council on Foreign Relations.  I'm joined by Sebastian Mallaby, who is director of CFR's Maurice R. Greenberg Center for Geoeconomic Studies and Paul A. Volcker Senior Fellow for International Economics.

For those of you who haven't visited the CFR website recently, I'd recommend to you the piece that Sebastian wrote a little while ago on the folly of U.S. debt brinksmanship.  Sebastian will also have a piece up on the website later this afternoon about the progress and substance of the Gang of Six proposal.  I also have a piece up on the  CFR website, which is linked back to a piece I did this weekend in the Outlook section of The Washington Post, on the consequences of a potential default for American power abroad.

I think what I'd like to do is to start off our conversation here by asking Sebastian a question about the Gang of Six.  What, exactly, is the Gang of Six proposing, and how likely is it to get us through the current stalemate on a debt-ceiling crisis, Sebastian?

SEBASTIAN MALLABY:  Well, thanks, Jim.  So the Gang of Six proposal envisages deficit reduction on the order of $3.7 trillion over a decade.  About three-quarters of those savings would come from spending cuts, with the rest coming from extra revenues.  Tax rates would actually be lower, not higher, but the extra revenues would be possible because presumably exemptions would be eliminated.

So it's a lot of cuts.  The cuts look as if they will probably end up being pretty close to the kind of package advocated by the Bowles-Simpson budget commission some months ago.  So this is an idea, a proposal, which is sort of in the mainstream, the bipartisan mainstream, and also within the technocratic consensus, in that, you know, the budget experts in the Bowles-Simpson commission came out pretty close to where this is.

The question you also ask is, you know, what's going to happen with it.  And I must say I sort of feel more optimistic now, in some ways, about the potential outcome for this game of "chicken" than I have done in a little while.  I'd say, relative to Europe, which I'm also watching, I'm sort of more optimistic that Washington will pull it out than I am that tomorrow's meeting of the European leaders will sort out the European debt crisis.  We can get to that if anybody on the call is interested.

My thinking on this Gang of Six idea is that not only has it got some, you know, three senators from each party proposing it; it's got, apparently, decent support on both sides of the aisle in the Senate. Not only that, of course, but the president came out immediately and supported it.  The sticking point is clearly the House.  But there Eric Cantor, who of the leadership duo has been the one who's been tougher to negotiate with over the last weeks, his reactions seem to be cautiously positive.  He said:  This bipartisan deal -- this bipartisan plan does seem to include some constructive ideas to deal with our debt.  So it doesn't sound like he's shutting the door.

It could be that polling data is coming in and suggesting that the American people do want a deal after all.  The Wall Street Journal/NBC polls do suggest a change on that question over the past month.  So maybe this is a case where if the centrists hang tough, a sort of bipartisan middle-ground kind of solution could actually end up winning.

MR. LINDSAY:  What is your expectation, Sebastian, of what's going to happen to a competing proposal that was passed yesterday in the House, called "cut, cap and balance"?

MR. MALLABY:  Well, I think it will simply die in the Senate.  I mean, that is a pretty radical proposal.

If you just take the balanced part of it, that's a suggestion for a constitutional amendment that would require the budget to be balanced, and I think it says at a rate where you'd have revenues of around 18 percent of GDP, that is a straitjacket that the nation simply couldn't live with, for one thing.  I mean, I think if you take the average share of federal spending in GDP over the last 10 years or so, it's been more like 21 percent than 18 percent, so it's not workable in that score.

It's also not workable simply because requiring the budget to be balanced naturally at all times takes off the table an important tool of macroeconomic management, namely the ability to run a deficit when you really need to, whether it's because of a war, whether it's because of a catastrophic recession -- you know, these kinds of straitjackets are really not sensible.  So I think it'll be dead on arrival in the Senate, and it would be vetoed by the president even if it got through the Senate.  So I don't see that going anywhere.

MR. LINDSAY:  Yeah, and I would -- I would note that in the vote cast yesterday was not enough votes to pass a constitutional amendment.  So it's not clear where this is going to go.

Sebastian, what do we know about the particulars of the Gang of Six proposal?  You laid out sort of the macro targets of 3.7 trillion (dollars) or so, split roughly 75 percent spending cuts to 25 percent revenue enhancement.  Do we know what in particular would get cut?  I -- what I -- my understanding is right now, this proposal exists as a four-page plan, which is not the same thing as a bill that the House or Senate can vote on.  And obviously, given the old saying that the devil is in the details, what gets cut is going to affect the politics on Capitol Hill.

MR. MALLABY:  Absolutely, I mean, I think the answer is, we don't know in any detail.  I'm looking here at a two-page summary which was circulated, and for example, it says, dramatically cut discretionary spending, and then it says, cut nonsecurity and security discretionary spending over 10 years.  Well, you know, thanks a lot for that.  It doesn't really tell you anything about which bits of the spending would be cut.

What I understand is that the plan would be to give the congressional committees in both chambers with jurisdiction over those categories of spending sort of caps, guidelines about the maximum they can spend.  And it would be up to them to figure out the details.  That's probably a recipe for the kind of horse trading and lobbying that, you know, doesn't necessarily get you to the most elegant solution.

So I mean, I think your question correctly puts a spotlight on the fact that there's a long way between this kind of general declaration and actually getting a finished deal.  And with the August 2nd deadline approaching, it's not clear there's time for that.

MR. LINDSAY:  (Inaudible) -- Sebastian, as you get closer and closer to the August 2nd deadline, there's obviously the potential that you could have a short-term extension or short-term raise of the debt ceiling.  I know the president has said he wouldn't do that, but I could imagine the appeal of doing it becomes greater if it is a way to get to this bigger grand bargain that we're talking about.

But you know, you spend a lot of time thinking about the markets and the financial markets, Sebastian.  As I sort of just try to sort of read what other government officials are saying, it seems to me that much of the commentary coming out of other major industrialized economies has been rather calm.  Many of the financial officials have been, you know, rather upbeat about the ability of the United States to figure out the problem.  Many have commented on the reality that there aren't obvious alternatives to the dollar as an investment vehicle or safe haven.  I know that the gentleman who's in charge of the Bank of Korea's foreign reserves has said he's optimistic that the United States will avoid facing a catastrophic situation.  One unnamed Japanese official was quoted as saying, holding onto Treasuries could cause some capital losses in case of a downgrade, but we could live with it.

So would just sort of take us through your assessment and thinking in the markets?

MR. MALLABY:  Sure, I mean, I would divide my thinking into two parts.  You know, one is in general, you know, is there a big question mark about the future of the dollar as a reserve currency, and is that a big deal?  And I think there, the answer is, yes and yes.  I mean, there is a question.  We've got, you know, repeated statements from Chinese officials of sort of, you know, we hate you guys, but we don't have any choice.

And we're still buying your debt, because we don't see anywhere else to buy it.

But, you know, it's not that -- when the reserve currency is unloved by the accumulators of those reserves -- namely, the central banks of countries like China -- you've got -- you know, you have a -- you're on thin ice.  I mean, they're buying the dollar assets, but they don't like it.  And so they're looking actively over a sort of long-term horizon to try to find an alternative.

And you can see some signs of people wanting alternatives in the very, very high gold price right now, as the people are buying gold as a different storer of value.  And you'd probably see more signs in terms of dollar weakness if it wasn't for the fact that we're in a kind of relative beauty contest here, and the euro hasn't been looking so beautiful.

So I do think that there are big questions about the dollar's future as a reserve currency.  And I also think that if the U.S. were to lose that privilege of having the reserve currency, it would affect American power because it would transform, you know, the key moments of foreign policy decision-making, which in the past have always been that you could decide to deploy U.S. troops abroad without worrying that the dollar would be shot to pieces -- and in fact, the dollar would typically strengthen, because it would be a moment of geopolitical strength and money would be flying into the United States because we've got the safest reserve asset.  So the odd thing was that in a situation like the Iraq war, you know, the Chinese or the Russians would vote against the U.S. in the Security Council of the U.N., in terms of whether the, you know, deployment was legitimate, and then they would sort of finance the deployment by buying more U.S. debt, because it was a moment of geopolitical stress and so money was flooding into dollars.

So that's been a kind of privilege in the past, that the U.S. has been able to zone out the possibility of stress on the dollar, stress on U.S. financial markets, and could make foreign policy decisions without worrying about all that.  And if we lost that privilege, it would be a big deal.

Now, do I think that this particular crisis is going to bring that moment -- sort of trigger that moment?  And I think, you know, the point -- the way to frame the answer is to say it's unlikely that this would happen.  But we're talking about a small probability of a  very catastrophic possibility.  I don't think it's likely that this will trigger a flight from the dollar, because I think, you know, all the statements you've been -- you recited in the first place show you that people don't feel there's an alternative.  In the very short term, what are you going to do if you don't want to hold dollars? There just isn't enough room in the gold market for everyone to go buy that much gold.

And, you know, you can make a sort of clever contrarian argument, as one of my colleagues here at the council, Matthew Klein, has been making to me, where he says, look, actually Treasurys would gain in value if there was no deal on the debt -- on the debt ceiling.  And his argument is that, look, you know, a debt ceiling -- if you hit the debt ceiling, you have no agreement to raise the debt ceiling.  That means the U.S. government can't issue any more debt, so there's no more Treasurys that investors can buy.  A lower supply of Treasurys means that the price of the Treasurys will go up.  Meantime, a lack of a deal on the -- on the debt means that government spending has to suddenly, you know, stop.  I mean, you have to cut it radically -- not stop it; cut it radically.  And therefore, you'd get a -- the U.S. economy going into recession.  That tends to be good for bonds.  So actually, Treasurys could gain in value in the short term, if there was a collapse in the negotiations and the debt ceiling was not lifted.

So, you know, in short-term, my bet is that Treasurys are fine. It doesn't mean I don't think that there are big existential questions for the dollar hanging out there in the background.

MR. LINDSAY:  OK, fair enough, Sebastian.

On that score, I'd like to invite people on the call who have questions to offer them up.  I believe our conference moderator will give you directions just now.

OPERATOR:  Thank you.  At this time, we will open the floor for questions.  (Gives queuing instructions.)

Our first question comes from Tom Curry from MSNBC.

Q:  Yes, this is for Sebastian Mallaby.  Do you -- a lot of people have noticed that the outline that was released yesterday by the Gang of Six -- it does mention some targets or goals as far as -- let's just take health care spending.

For example, it says if health care spending isn't reduced by a certain amount per capita or per beneficiary, then the -- I guess it would be the Budget Committee would be instructed to take action, and I think 2020 is the year they mentioned.

Due to the lack of specifics here and putting things off into the future -- which is what, you know, the president and other people say they don't want to do, but that's what the plan does when it comes to health care spending -- is the point, from your -- is the point of the plan to have credibility with the ratings agencies and with the bond markets?  Or is the point of this plan simply to give members something to vote for to kind of get them past the immediate debt ceiling vote?  Because you -- I think the lack of specifics raises questions about, well, would any of this stuff be done?

MR. MALLABY:  Sure.  I mean, that is absolutely a fair question. And if you kind of game it out, and you think to yourself, well, it's just not possible to put all the details into this plan in the time available, therefore if the plan is going to be useful as a compromise vehicle to get through the debt ceiling crunch, it's going to have to be passed in a kind of outline version with the dot, dot, dots to be filled in later.  Who's to say that they will be filled in later? Perhaps they might not be.

And I -- I'm not enough of a legislative tactician -- maybe Jim Lindsay can help you -- to know how you would sort of bind -- how Congress would bind itself in terms of delivering on some kind of promise to fill in those dots appropriately.

MR. LINDSAY:  I mean, obviously, you know, I think the Gang of Six proposal is trying to accomplish two things.  One is to get the debt ceiling raised so we don't jump into the unknown, where a number of the potential bad things Sebastian laid out could occur.  But second, I do think there is a general desire to want to put the U.S. government's fiscal house on a more sustainable path and a recognition that this is an opportunity to strike that bargain and, in a way, by committing both parties, take it out of or reduce its role in the 2012 election.

I mean, I think Sebastian is optimistic about the ability to enact the proposal.  The problem you're going to have is this very question of how you make the bargain endorsable, and there are a variety of legislative tactics to do so.  But by the very nature of time allotted to the task, there's going to be a lot of unanswered questions, and that in and of itself becomes one of the liabilities or obstacles as you negotiate the legislative process, because people will raise the objection that they're voting to give up, from the Republican point of view, their great leverage; it's unclear what they're going to get.  I think the response from the White House should be, as a practical matter we are where we are; we don't have time to write a detailed legislative vehicle.

The second thing is that there is also -- there are also political benefits for not being terribly specific about what the cuts are going to be, because once you start outlining cuts, you begin -- specific cuts -- you begin to mobilize groups who have a stake perhaps in seeing a new fiscal plan, but one that does not harm their interests.

MR. MALLABY:  I would just -- also I'm thinking about what happens if you don't get a deal by August the 2nd.  Well, on August the 3rd -- I was just reading a good piece of analysis from Barclays Capital, which points out that on August the 3rd, there is a $23 billion payment due to Social Security beneficiaries, and over the next, sort of, eight business days, up to August the 15th, there is a projected cash shortfall of $74 billion.  In other words, if the government couldn't borrow any money, it would have to just think of $74 billion of emergency cuts over eight days.

So there would be a heck of a lot of checks that the government would ordinarily be writing that couldn't be written.  And politically, if we don't have a deal and the administration is saying, you know, to the American people, gee, we'd like to be making good on these obligations, but sorry, Grandma can't have her check because Congress is dithering, you know, you wonder whether that actually might somewhat speed up the process of coming up with a sensible compromise.

MR. LINDSAY:  I think that was the reason why the president made the point last week he could not guarantee payment of Social Security checks.

MR. MALLABY:  Yeah.

(Pause.)  Shall we see if there's another question?

OPERATOR:  Thank you.  Our next question comes from Jim Wainars (ph) from Dallas Morning News.

Q:  The comment you made about being more optimistic about Washington than Europe caught my eye.  I am interested in why you're so negative on that and why, frankly, Americans should care if the Europeans simply keep kicking the can down the road.

MR. MALLABY:  Well, you know, I'm negative on Europe because I think that they are stuck in a sort of -- a version of our political conundrum, but they show less ability to close the gap.

And what I mean is that on the one hand you've got sort of the equivalent of the Tea Party, the northern European parts of the euro zone -- Germany, Finland, Holland.  And these guys don't want to be spraying taxpayers' money around, they don't want to transfer it too much to Greece and they don't want to do it either for, you know, other countries that might get into trouble, such as Italy or Spain. And so they're always kind of pushing a hard line on how much they're willing to pay out to rescue the crisis countries.

So what we've seen repeatedly is that this produces crisis solutions where, you know, European leaders feel they can't let the euro just collapse, so they do produce a package for Greece, they do it for Portugal, they do it for Ireland, but each time they design terms of the rescue package which are extremely stringent on the Greeks or the Irish or -- particularly the Greeks and the Irish.  And they have to be stringent, because otherwise taxpayers in these northern European euro zone-member countries are going to furious.

So this produces this repeated dynamic of kind of sort of bailing out but at the same time saying, we're not really bailing you out and you have to pay a very high interest rate on this money we're giving you -- and therefore, at each point, the bailout isn't credible.  Bond markets can see that it ain't going to work.  You're going to have to refinance it six months or a year down the road, and nobody is persuaded that the system is being put on a sustainable trajectory.

So not surprisingly, bond market investors don't want to buy the debt of countries which aren't on a sustainable footing, therefore the interest rates of these peripheral European countries keep on going up because bond markets don't want to finance the debt which may not be paid back, and those high interest rates further strangle the economies of these peripheral Europeans, guaranteeing that these halfhearted bailout packages won't work.

And what's different now relative to two weeks ago is that before, it was simply these very small economies.  I mean, the Greek debt problem -- I was reading that, you know, the package that may be put together tomorrow -- the designers of the package calculate that the money -- the additional money that Greece needs over three years is 115 billion euros, which is sort of 150 -- $150 billion.  So that's, you know, peanuts compared to the kinds of money we're talking about with $3.7 trillion of cuts over 10 years in the U.S. deal.  So it's been too small thus far to really rock the world economy, but when it gets to a country like Italy, which is the third-biggest member of the euro zone, then it becomes serious.  Then it becomes the kind of thing which could seriously derail any sort of global economic recovery.

So I think, you know, this is primarily something that Europeans have to worry about, but there is a secondary concern for the United States in terms of capital market repercussions and in terms of export markets sort of drying up if the Europeans go into a major recession. And I just think that the politics of Europe are more intractable than the politics of Washington, if you can believe that.

OPERATOR:  Thank you.

Our next question comes from Alex Benedetto from Energy Intelligence Group.

Q:  Hi, thanks for holding this.

The question is again regarding European debt crisis.  And you're speaking about Spain and Italy right now.  There is rising concern of Greece's debt issues overflowing into those countries, and obviously it seems to have already done so, especially in Italy with the package they have proposed.

I'm looking more from an energy perspective on it, obviously, and I wanted to see if you had any thoughts regarding how the debt crisis in Europe could be impacting the energy market, especially in Western Europe, not necessarily anything in particular, but just maybe with investing and that type of sort of thing.

MR. MALLABY:  Well, I mean, you know, I can just make two quick points on that.  I mean, one is obviously that if you've got slowing euro zone growth because of the spreading of these debt problems that, other things equal, reduces the demand for energy and takes the pressure off prices.

The second point I'd make, which goes slightly in the opposite direction, is that, you know, one, I think, very plausible way out of the -- you know, sort of next step in the European drama is that the European Central Bank, which has stringently resisted getting too much dragged into bailing everybody out because it wants the politicians to do that, may finally conclude that the politicians ain't going to do that, and it's too much of a crisis if the European Central Bank holds back.  So if they conclude that, then you get a kind of U.S. Federal Reserve type of response after Lehman Brothers, where Bernanke said, you know, whatever it takes, we're going to save the system.  If the ECB sets its position in sort of saying whatever it takes, we're going to save the euro by simply buying Italian government debt -- which actually, the -- you know, I mean, the European Central Bank can print euros.  It can buy all those distressed debt and rescue the system like that.

But if it does that, that's going to stoke the same kinds of inflation fears that you had with respect to quantitative easing in the United States.  And obviously, that kind of psychology feeds into very high commodity prices, because people are fleeing paper money, which they believe is going to be inflated away, in favor of real assets, including energy.

OPERATOR:  Thank you.

Our next question comes from Denise Kristin (sp) from -- (inaudible).

Q:  Thank you for this opportunity to talk with you.  I wanted to know if it is possible to calculate the GDP for United States, or to have an idea about it.  And that the second semester and next year regarding this Gang of Six proposal, is it possible to have a recession, a new recession, if this -- if this plan is put in practical (sic)?

MR. MALLABY:  Well, I mean, to really do an estimate of the near- term effects of this kind of plan, you'd need to, you know, see the numbers:  how much are the cuts going to be near-term and how much are going to be further out.  I think that the outline that's been circulated does say something to the effect that -- immediate deficit reduction down payment of 500 billion (dollars).

Now, what does "immediately" mean?  But let's suppose that it meant over the first year, right?  So 500 billion (dollars) off demand -- 500 billion (dollars), you know, reduction in spending in the economy, in a 14 trillion (-dollar) economy, roughly.

I mean, you can do the math, but we're talking, you know, I guess, sort of, two or three percentage points off demand.

So if that really were to be implemented, you know, that does feel pretty contractionary, just in terms of reducing total demand in the economy.  And since we're not in a -- by any means a strong growth position at the moment, you'd start to worry about a double dip.

Now, the problem is that all things aren't always equal, and, you now, if this package were to pass, it would increase the likelihood of the Fed pursuing an easier monetary policy to compensate, because the Fed doesn't want to see growth going negative and would expect inflation to go down in a very weak growth outlook.

So I think it's basically too complicated to do that kind of projection at the moment, but I've given you some of the ways of thinking about it.

Q:  But may I follow up?

MR. MALLABY:  Sure.

Q:  But you said that the monetary policy should compensate as == reducing in the growth -- economic growth.  Do you expect that the Fed can put forward the idea of a QE3?

MR. MALLABY:  Well, I mean, as you know, there was a debate about that recently and the Fed decided not t do it.  But I don't think it's off the table.  You know, if we find that six months from now both growth is slow to negative and price pressure -- that is, inflation -- is falling, then I think the Fed will be as pragmatic as it been consistently since the Lehman Brothers crisis.

In other words, when it sees the economy falling off a cliff, it jumps in and it rescues it.

Now, I don't think that QE3 -- you know, they decided not to do it now, but I don't think it's off the table for sure looking into the future.

Q:  Thank you.

OPERATOR:  Thank you.  (Gives queueing instructions.)

There are no further questions at this time.

MR. LINDSAY:  Well, I want to thank everyone for joining us, but let me give Sebastian the opportunity, if there are any other observations he wants to make about the debt ceiling issue and maybe also the potential, Sebastian, that if we -- if you are able to strike a deal that -- particularly a -- one along the lines of the Gang of Six, whether that will do much to change market psychology.  There's been a lot of talk about uncertainty inhibiting investment, questions about changes to the tax code.  Is it possible that this deal could fundamentally change psychology out there, so rather than being contractionary, be expansionary?

MR. MALLABY:  You know, you're touching on a pretty heated debate amongst economists, maybe more heated in Europe, actually, than in the U.S., where this idea of an expansionary austerity, that by, you know, cutting your budget deficit, you can actually encourage growth, has been quite popular amongst policymakers in Germany and elsewhere in Europe.

I think that the evidence is not on the side of people who say that, that it basically -- the sort of crude math that if the government spends less, you've got less total demand in the economy; and unless you've got some theory why private individuals will suddenly start spending more, it's going to be growth reducing.

So what I expect in the markets if there is a deal is that the first reaction would be, you know, what a relief; you know, they haven't done something crazy with the debt, and they haven't, you know, threatened to stop paying people, and immediate kind of chaos and uncertainty has been reduced.  So markets will be happy, just like they did respond positively yesterday after the president wrapped his arms around the Gang of Six proposal.  So that's the first sort of positive, happy reaction.

But then I think, you know, pretty soon after that, you settle into the realization that, A, a lot of the details in the Gang of Six proposal will not have been filled in, so uncertainty still is there; B, insofar as you know what's in the proposal, it's basically going to be a lot of austerity, and austerity is bad for growth, so that's going to be a negative for the markets; and C, to the extent that the full faith and credit of the United States as a borrower has been reaffirmed and that triggers capital flowing into the United States, it's going to push the dollar up.  You've got a continued crisis in Europe, so the euro will probably be weak, and meanwhile, you've got a certain amount of currency manipulation, shall we say, in emerging Asia, meaning that they're probably not going to allow themselves to appreciate against the dollar, particularly when the dollar is already rising against the euro.

And so, sort of, you know, dollar strength, other things equal, is not good for U.S. growth, right?  It reduces exports and increases imports.

So for all these reasons, I think the basic, fundamental sort of logic of the economic outlook is going to be pretty depressing.  And so the happiness around a deal in Washington may be rather short- lived.

MR. LINDSAY:  Well, there being no more questions, let me thank Sebastian for his, as usual, incisive analysis.  And thank all of you for joining us on this call.

And we'd like to invite all of you from -- who want more information on the debt ceiling debate to please check out the council's website, cfr.org.

Thanks.

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