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U.S. Solvency Rests With 12 Angry Men

Author: Benn Steil, Senior Fellow and Director of International Economics
August 8, 2011
Financial News


Thanks to the legislative heroics of the 112th Congress, the American government will continue to pay its bills. You are welcome.

If reserve currency status were awarded for political maturity, the Greek socialist government could bring back the drachma and China would be stuffing its coffers with it. Instead, we've witnessed the incredible spectacle of the US government, the actual guardians of this exorbitant privilege, wilfully pushing their country to the edge of a catastrophic default.

Chinese central bank governor Zhou Xiaochuan called the US debt squabbling a “madcap farce”. Russian prime minister Vladimir Putin labelled the United States “a parasite”. China and Russia together have amassed $1.28 trillion in American IOUs, though both are considering selling them for iPads.

The degree of reckless self-indulgence that has overtaken American economic policymaking is truly breathtaking. The United States treats the eurozone with disdain because it cannot get 17 sovereign nations to improvise a massive, continent-wide fiscal overhaul quickly enough, yet when it comes to passing a single piece of legislation permitting the country to continue servicing its existing debts Washington goes into a self-imposed state of puerile paralysis.

In the grips of a sort of suicidal fiscal millennialism, followers of anti-tax cult leader Grover Norquist held the world hostage for weeks. Cut spending, they insisted, or we'll bring on precisely the economic Armageddon we've been warning about. This would, of course, worsen the country's debt burden – but, hey, what price principle?

Not that they are opposed to government largesse, mind you. In fact, they consider the entire perverted panoply of rebates and exemptions in the tax code sacrosanct. Don't touch subsidies for debt financing. Don't even think of cutting ethanol subsidies. Actually, they'd be only too pleased to swell the deficit by adding gun-buying to the arsenal of tax-deductible pleasures.

And these are, incidentally, many of the same folks who backed the 2005 Bankruptcy Reform Act on the grounds that default was a form of moral turpitude.

As for the president, he emerges from the drama looking weak-willed and rudderless. Having appointed a fiscal commission in 2010 from which a majority compromised on a remarkably sane and bold plan, comprising entitlement and tax reform and significant defence cuts, he then left it high and dry. He produced his own budget in February that not only ducked these issues, but relied on gimmickry to provide a patina of prudence. Starting from the political imperative of showing no rise in the debt-to-GDP ratio over the next 10 years, the budget was then reverse-engineered to produce this result painlessly by assuming growth figures of 4.4% for fiscal year 2013 and 4.3% for 2014. These numbers were barely credible when they were released – about 1.5% above private forecasts – but now look downright ridiculous as the economy slouches towards recession.

Last week's 11th-hour deal, which raised the debt ceiling for the 75th time in the past 50 years, does little to put the United States on a path to fiscal sustainability. The $917bn in deficit cuts called for over the next decade amount to less than a quarter of what would be necessary to keep the debt-to-GDP ratio from rising yet further. And since all the cuts come from discretionary spending which Congress can, in the annual spending approval process, reverse at its discretion, the deal is less a commitment than a New Year's resolution.

As for the new commission Congress will appoint to deal with the much harder issues of taxes and entitlements, the outlook is bleak. Twelve Angry Men, six from each party, will be chosen based on their commitment to not compromising, and there will be no Henry Fonda in the room to bring them to reason. When they fail to arrive by November 23 at an agreement on $1.5 trillion in new deficit cuts over the next 10 years, this will trigger an automatic chopping of an additional $700bn in non-entitlement domestic spending and $500bn in defence spending. Whatever one thinks of the need for fiscal paring, this cannot be a responsible way to go about it – particularly on policy areas as consequential as national security. It would also leave Medicare, Medicaid, and Social Security – 40% of federal expenditures and growing – on autopilot.

For the Treasury, adding insult to injury is the fact that the ink had barely dried on the debt deal when S&P whacked it with a downgrade. The Treasury must wonder what happened to the good old pliant raters who slapped a triple-A on any CDO-cubed you stuck under their noses. But he who pays the rater calls the rating, and Uncle Sam doesn't pony up for triple-As like the private issuers do.

Should we care what the rating agencies think? When the agencies rate private debt they may be on the take, but at least they get access to privileged financial data. So they're arguably in a position to know something. In the case of sovereigns, however, they don't know a thing the rest of us don't. But since downgrades trigger automatic selling and purchase-restriction directives hardwired into public and private investment fund guidelines, they will push up borrowing rates even if the agencies were to admit to searching for default clues in chicken entrails.

All this bad news from Washington has, fortunately, brought some good news for Europe. Google references to “Washington is dysfunctional” now outnumber those to “Europe is dysfunctional” by a record 1.3 million.

You are welcome.

--Benn Steil is director of international economics at the Council on Foreign Relations and a winner of the 2010 Hayek Book Prize



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