Standard & Poors' downgrading of U.S. debt on August 5 merely confirmed what any observer of Washington has known for a long time: The U.S. government has no credible plan to tackle the unsustainable deficits forecasted for 2015 and beyond. The new information this summer is that a partisan, gridlocked U.S. political system has injected a new level of uncertainty into markets.
A year ago I asked the question, "How dangerous is U.S. government debt?" At that time, the worry was that medium-term debt dynamics were so adverse that U.S. debt would become unsustainable and that investors would fund U.S. government borrowing only at sharply higher interest rates.
After nine years of declining revenues and increasing expenditures, the United States had amassed $11 trillion in debt, an amount equivalent to roughly 75 percent of annual GDP. More worrying were the projections that the debt would increase sharply from that already high level. Why would the debt increase so much? There has been, for roughly the past decade, a simple imbalance between revenue (not enough) and expenditure (too much). And an important part of the future increases in expenditure are hard-wired through entitlement spending, especially the unfunded liabilities related to healthcare and an aging society.
In 2010, the specter of wholesale selling of U.S. Treasury debt was alleviated by the eurozone debt crisis. Large investors were signaling their distaste for U.S. bonds, but they had nowhere else to turn. Had there been a reasonable alternative, one would have expected sustained selling of U.S. bonds by both domestic and foreign investors, which would leave the United States--and not just the government--with sharply higher borrowing costs.
Fast forward to this year. Washington's recent political clash over the debt and (future) deficits problem ended with a deal that decreases budget deficits by an estimated $2.1 trillion over the next ten years. Yet this is unlikely to improve the sustainability of U.S. debt. A fundamental driver of expected increases in expenditure--Medicare and Medicaid spending--was left largely unaddressed. Another cause of the imbalance Washington has had during the past decade--revenue that is far too low--was not addressed at all.
In its failure to address the sustainability of U.S. debt the government has taken a hit. Among the recent troubling signals:
- Washington can concoct a crisis about something as mundane as the debt limit.
- Washington is willing to raise doubts about its willingness to pay bills on past spending and borrowing--spending and borrowing that Congress itself approved.
- The U.S. government is willing to expend enormous effort on all this--at a time of great uncertainty about the economy--and at the same time fail to curb the fundamental drivers of the expected growth in U.S. debt.
Washington gets away with this behavior only because the U.S. Treasury bond market is still the world's pre-eminent market. But the U.S. Treasury market, while still large, homogenous, and liquid--features attractive to investors needing to place a large amount of funds--now has an element of uncertainty. This uncertainty, obvious before Standard & Poors' announcement, has been broadcast loud and clear through the downgrade.
Investors domestically and abroad now wish the world had another "risk-free" asset, one that would reduce investors' reliance on U.S. Treasury bonds.
Investors domestically and abroad now wish the world had another "risk-free" asset, one that would reduce investors' reliance on U.S. Treasury bonds. And the antics of Washington may well prompt other countries to develop just that market. Early in the twentieth century, England's pound sterling lost its dominance in global financial markets in part because of the government's own doing: Massive wartime debts and a wildly volatile currency prompted the search for alternatives. But part of the pound's decline was brought about because other countries saw an opportunity; the U.S. Federal Reserve, in particular, moved to increase the importance of the dollar in the market in trade acceptances.
Today, it would take a multi-step process for the dollar to lose its role as the global reserve currency; it could well be that this summer we have witnessed a few steps in that process. A government that puts the world's risk-free asset at risk to attain, in the end, next to nothing, is not one that inspires confidence. And this loss of confidence will provide incentives to investors to search elsewhere for stores of value and to other borrowers to create them.
The problem with U.S. debt is in the medium term--2015 and beyond--it will be driven by unfunded liabilities that will keep increasing and revenues that will remain insufficient. Washington, by avoiding all of the tough issues, has done nothing to shore up the medium-term prospects for U.S. debt.
A year ago, at least we could say that in the midst of the global financial crisis the U.S. government had acted to avoid a depression. Today all we can say is that the U.S. government can come to an agreement that fails to address the fundamental factors that will lead to a real debt crisis. The difficult discussions about what exactly the U.S. government should fund and how exactly it should raise revenue to match those expenditures will have to wait for another day.
In the meantime, we all can hope that investors here and abroad do not become so worried about the U.S. government's ability to deal with the looming debt crisis that they move out of the Treasury market, sending borrowing costs sharply higher, further wobbling an already weak economy. The dollar would weaken, which might be the only stimulus package Washington can hope for, but one whose impact would be vastly overpowered by the concomitant increase in borrowing costs.
Better would be a strategy to squash the looming debt crisis. Tax and spending policies must be changed so that the budget will be balanced or in surplus in good times, allowing for small deficits in times of slack economic growth. But first lawmakers need to embark on a transparent process to correct the fundamental imbalance in tax and spending. The specific proposals, which could include everything from instituting a Value Added Tax to eliminating mortgage interest deductions on the revenue side, to dramatic reforms to healthcare programs on the spending side, can come out of a conversation that policymakers have with the American public.
The U.S. government should not, as it did this summer, start with an outcome (the amount of debt) and back into temporary solutions. Rather, it must start with tough choices on fundamental drivers of the problem (imbalances in tax and spending policies) to get to an acceptable outcome. Its creditors await action.