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Reviving U.S. Economic Leadership

Interviewee: A. Michael Spence, Distinguished Visiting Fellow
Interviewer: Christopher Alessi
August 24, 2011

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Standard and Poor's historic downgrade of U.S. debt on August 5 damaged the United States' global reputation, but U.S. treasuries are still the safest asset in the world (Reuters). But that will certainly change if the United States does not enact long-term, bipartisan measures to reduce its fiscal deficit and debt-to-GDP ratio, says Nobel Prize winning economist A. Michael Spence. International investors are more concerned by political inaction in Washington than by the downgrade. "The debate in Washington seems to be deadlocked on taxes and the size and role of government--and restoring economic and financial health seems to be sidelined in the process," says Spence. At the same time, he explains, the ballooning U.S. debt crisis, coupled with that of the eurozone, is contributing to a global economic slowdown.

How, if at all, has the United States' role in the world shifted following this month's S&P downgrade?

Our reputation was damaged, mainly by allowing the integrity of our sovereign debt to be in question. The S&P downgrade reflected that, though I think it was premature. The political gridlock over fiscal stabilization and growth is also damaging our reputation externally; the downgrade also reflected that.

U.S. treasuries continue to remain the safest bet for global investors. Can that be maintained?

Yes, but not if we cannot find a way to progress to a credible--meaning with bipartisan support--five to seven year plan for the restoration of fiscal stability. [That] means reduced deficits, growth to get the debt-to-GDP ratio down to safe levels--50 to 60 percent--and plans to eliminate, reduce, or fund future liabilities, which are rising.

What does the downgrade signify for the role of the U.S. dollar as the world's reserve currency, and is an alternative likely to emerge?

Not in the short run. It means the only viable reserve currency is less safe. The euro may stabilize and become a second reserve currency. The yuan will expand its role in trade settlement [and in global] value, but cannot function as a reserve currency for at least a decade. [The yuan] needs capital controls and exchange rate management. Perhaps over time, after the current volatility and issues in Europe and the United States are behind us, some sort of international reserve currency could be created. But that is some time in the future.

The market volatility is really a reflection of declining growth prospects combined with political inaction or gridlock.

You have written about the "inadequacy of policy responses" to the debt crisis. What policies, then, should the United States pursue in order to restore international faith in its credit and its economy at large?

The main item is fiscal balance. But restoring growth and employment is key, too. We are not making progress on the first and are only starting to address the second two, despite all of the talk. Once that is done, and we are back on a sustainable growth path--with a balance on the trade account, as well--the Fed can unwind the balance sheet expansion. What worries investors and others is that the debate in Washington seems to be deadlocked on taxes and the size and role of government--and restoring economic and financial health seems to be sidelined in the process.

We need to decide on a sensible plan to reduce deficits over five to seven years, without doing it too fast and flattening the economy. Part of that plan has to include investment in people, skills, competitiveness, and technology in various sectors of the tradable part of the economy, so that it becomes an employment engine. Remember we had excess domestic demand, and lost it in the crisis; to do this requires real sacrifice in the short run.

The employment problem is structural and that takes time to change. Probably five years or so, perhaps more. It cannot be done with incomes and consumption levels at their current levels. [Consumption levels] need to adjust down and saving and investment [levels] up. We have been living beyond our means and expectations are still set there, with the current difficulty being regarded as somehow temporary. We need to share the burden and take care of the unemployed. I would suggest a limited-term surtax to fund this.

What policy steps can the Fed take to restore confidence?

The Fed is doing what it can--and that is mainly not to do anything to damage a fragile return to economic health. But it cannot restore fiscal balance, address other structural and competitiveness issues, and tackle related employment challenges. It may help, but it is a misconception of their instruments, mandate, and powers to think the Fed can do this alone. That kind of thinking produces lack of action in other areas and further delays in restarting the economy.

How do the U.S. and European debt crises compare?

Both are the result of a combination of fiscal imbalances, and growth and productivity problems. But there are differences: Several European countries [peripheral economies, like that of Greece] used excess public sector debt to sustain growth and employment, benefiting from [access to] the euro and low interest rates. The United States--along with Britain and Spain--used excess private-sector debt to produce an unsustainable growth pattern. Then, with the financial crisis and the response, the private sector deleveraged and the public sector leveraged up to compensate. And now we find ourselves in similar positions.

Europe, however, has a multi-country discussion and burden-sharing to get through. That makes [finding policy solutions] harder than it should be in the United States.

The Fed cannot restore fiscal balance, address other structural and competitiveness issues, and tackle related employment challenges.

What's the joint impact of the two crises on the global economy?

A global slowdown, including in some of the emerging economies. The latter can keep up high growth if we are stalled, but not if we take a big downturn. Too much export demand will be lost.

What does recent the global market volatility mean for both the U.S. and global economic outlook?

The market volatility is really a reflection of declining growth prospects combined with political inaction or gridlock. Prices are resetting downward to reflect the headwinds for growth and the more realistic growth expectations. Policy uncertainty is contributing to risk and volatility--all not great for the outlook.

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