Wednesday, October 5, 2011

A Midsummer Debt Freakout.

For August 2011 issue of Zahranicna Politika

Did you know the US could go bankrupt any day now?  While various European nations have been battling with the specter of debt defaults, the United States has been sitting there happily and smugly.  Sure, there have been enormous deficits of late in the land of the free.  However, no one ever questioned the credit-worthiness of the US.  That is, until very recently, when the government has been scrambling to raise the “debt ceiling”.  How is it that the US is suddenly looking at the possibility of defaulting on its debt?  Is this crisis real or is America just suffering from default-envy?

First, several terms and concepts need to be explained.  The notion of the US government not defaulting on its debts is so self-evident and central to economic and financial theory, that the interest rate that the US pays on its obligation is referred to as “the risk-free rate”.  In other words, every other asset - with the exception of cash - carries a certain level of risk, and the return that investors expect to make for holding that asset is a compensation for that amount of risk.  A Greek government bond, for example, will pay a higher rate because it is more risky than a German government bond.  The US government - due to its sheer size and clean history of debt repayment - has always been considered so safe that the rate it pays on its debts is the lowest of them all.  Another illustration:  whenever there is a crisis - a recessions, a war, a natural disaster - and the stock markets start panicking, the asset that everyone parks their money is US government debt.  This phenomenon is known as “flight to safety”.  You get the point.

So how does a country go from being the safest place on earth to park your money to potentially defaulting on its debt in such short order?  This is where the concept of a “debt ceiling” comes in.  While the US can borrow at incredibly low rates, the overall amount it can borrow is limited by law.  Historically, the US Congress had to approve each issuance of debt separately.  During the World War 1, when this became impractical, the Congress gave the Treasury the right to issue debt as they see fit in order to meet the government’s funding needs.  However, in exchange for this flexibility, the Congress put in place a cap on the overall amount of debt.  Through the years, this cap, or ceiling, has been raised dozens of times, whenever it was necessary.  And so, even as recently as a few weeks ago, no one thought this would actually be an issue - of course the Congress would vote to raise the ceiling if it’s needed to fund the government.  Otherwise, without the ability to issue new debt, the US would actually need to declare default, and that is obviously not going to happen.  Right?

As a reminder, if the US were to default on its debts, the securities which were previously considered risk-free by everyone would no longer be so risk-free.  US government interest rates would go up - and perhaps more importantly - all other interest rates would follow.  This would mean that anyone with any debt - a mortgage owner, a businessman, a student - would be facing higher costs of interest.  The consequences would be so wide reaching and dire that it is not an exaggeration to think that a global recession, if not a second Great Depression, would follow.

Well, perhaps this isn’t so obviously to the folks in the US Congress.  While every normal person simply assumed that the debt ceiling would be raised, the Republicans figured:  here’s something that needs to get done - let’s get something in return!  And since cutting spending is the Republican mantra, the little treat they asked for in return is a $4 trillion cut in government spending.

The frustrating thing about the economic discourse in the US is that there is not a single issue that can ever be a purely economic one.  Before long, everything becomes another tool in the never ending ideological war between Democrat and Republicans, liberals and conservatives.  And so while things like the social safety net and even the phenomenon of taxation are non-controversial issues in the old continent - hello! we need some of both! - nothing is ever considered settled in the US.  Which is how what should have been a total no-brainer became a heated issue.  While everyone agrees the debt ceiling needs to be raised, the controversy flared up around how to cut the deficit - an important issue, maybe - but one that needn’t be considered at the same time as the decision about whether or not we allow the economy fall from a cliff.

The other fascinating phenomenon in the never-ending ideological war is that the answers are always the same, at least from one side.  It simply doesn’t matter what is going on with the economy or with incomes or with unemployment - for a Republican, raising taxes is always bad.  Naturally, when we are trying to plug a multi-trillion dollar hole in the budget, it might make sense to at least consider raising some taxes.  Instead, Republicans counter that raising taxes is bad because it would kill jobs (a cool sounding motto which no one has ever bothered to prove).  And yet, somehow, it must be magic!, the spending cuts they propose are automatically assumed to occur in a complete vacuum from the rest of the economy.  Simply put, this is complete nonsense.  A core macro-economic formula says it all:  GDP = C (consumer spending) + I (capital investments) + G (government spending).  Cutting spending can’t not hurt the economy and employment.

The US officially runs out of money on August 2nd and yet an agreement is nowhere in sight.  In the meantime, Standard and Poors, the credit rating agency, has been watching the two parties negotiate and declared that their stunning inability to find a compromise this close to the deadline might lead them to downgrade the US debt even if they do find one eventually, leading to raising rates, economic slowdown, etc.  One can’t watch this self-inflicted mess without thinking: do Americans feel like life would be more fun an actual debt crisis?  If so, there are a few European countries I can recommend for them to move to.  For the rest of us, fingers crossed that cooler heads with brains prevail.  

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