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The World's Problem with the US's Debt Problem
The American television drama, complete with clocks ticking toward a default Armageddon, has finally ended. It was always more theater than real crisis. Markets rightly guessed that even US politicians would balk at responsibility for default.
The dollar has weakened, but there has been no mass flight from US bonds or a repeat of the contagion which followed the collapse of Lehman Brothers in 2008. Those who wanted to flee the US bond market have few places to go other than speculations like gold. But meanwhile the US has made a fool of itself and raised the long-term cost of government borrowing.
This episode has rightly drawn attention to three major and partly-linked problems that must be addressed if the world as we know it, the post-1945 system created under US auspices and underpinned by institutions such as the World Trade Organization and International Monetary Fund, is not to come to a disordered and protectionist end.
The most immediate of these problems is the dysfunction of the US political system. For sure, the division of power between president and Congress, and between the two houses of Congress, is part of the strength of the US federal system and underpins its plural democracy.
In the past, disputes largely between the two major parties or between president and Congress have seldom been taken to the point of seriously damaging the US position in the world. The debt issue is as much part of foreign policy as key treaties such as NATO. America’s friends and its enemies could generally rely on a Washington consensus straddling mainstream US politics and expressing itself in the policies of the State Department and the Treasury. No longer.
It’s not clear to an outsider whether the shrill divisiveness of US politics is more than temporary. Whatever its cause – the gerrymandering of electoral boundaries, post-9/11 religious and nationalistic fervor, the abysmal level of debate in the media or the poor understanding of foreign affairs of many US Congressmen – the division matters to the world.
There have been many times when Congress has thwarted the executive’s policies, such as the hold-up of free trade deals. But the decline of US governance is worrying not just for US allies but for rivals, such as China, which want to compete with the US but broadly within today’s international economic framework. The influence of the US overseas had already been eroded by its domestic politics, and the debt issue simply put this on the front pages as the world has been staggered that congressmen can put US reputation at such risk over sums of budget money almost irrelevant to the longer term of stabilization of debt.
That debt is indeed a serious long-term problem even without extrapolating this year’s peak just shy of 10 percent of GDP into the future. But what immediately strikes many foreigners as barely comprehensible is such resistance to taxes even though the US is very lowly taxed by most developed country standards – revenue is only 15 percent of GDP -- despite its huge military, medical and welfare expenditures. Resistance to ending tax breaks for favored sectors among those who purport to believe in free markets is even more bizarre.
Political grandstanding has emphasized the difficulty the US has in addressing a problem that all can understand and for which solutions are not available. Dysfunctional politics is also apparent in some important debt-ridden states, notably California.
So how bad is the overall deficit problem? It is little more than a decade since, under Clinton, the US government was in surplus. Subsequent turn-around factors included the cost of post-9/11 wars, tax cuts under George W Bush which have since been extended, bailouts of financial institutions following the 2008 crisis and shrinkage in revenues. The latter was the result of the ending of stock and property booms which had caused a surge in revenue from various taxes, and then the impact of the recession which began in 2008.
Now the US needs to sustain government deficits to in turn sustain modest economic growth because overstretched consumers are retrenching and corporations are making good profits but hoarding their cash. So part of the problem is a cyclical one made worse by the political mess and unwillingness to roll back tax cuts for the rich and plug loopholes.
The structural part is more the result of demography than anything else. As baby boomers age the health, welfare and pension burden increases. Over time expectations of what the government can do must be reined in, and the working population will have to do more, whether by taxes or family support, to sustain the old. The US is in a better position than almost all other developed countries – and some developing ones – thanks to immigration and a fertility rate that’s among the highest in the rich world. But demography could yet be trumped by political failure to take action.
Cyclical revenue improvements plus military and other spending cuts may reduce deficits over the medium term – three to five years. However, without plans to resolve deficit issues over the longer term, markets will remain nervous, and companies and households reluctant to spend. The world economy will be hurt and consequently the US ability to trade its way out of trouble.
That brings us to the third problem, perhaps the most fundamental: years of US current account deficit ranging from 3 to 6 percent of GDP, the result more of excessive US consumption than of government deficits. Japan’s government debt is 70 percent more than the US as a percentage of GDP and its demographic outlook far worse. So why have people been dumping dollars for yen? Simply because the Japanese deficit is financed at home while 47 percent of US publicly held government debt is now owned by foreigners.
The US has been able to finance its excess consumption because of the reserve currency role of the US dollar and the zeal of central banks such as those of China to keep their currencies depressed and trade surpluses high by buying US debt. China is naturally worried about the decline in the value of the dollar and the threat of debt default, but also needs to appreciate its own role in creating the imbalance. It has long been a Faustian bargain that many thought would end in tears.
The recent recession and dollar falls have not yet done enough to rebalance trade and increase US savings so that citizens rather than foreigners finance its government. So the debt issue may have a silver lining, reminding China and others of the futility of excessive foreign reserve acquisition. Eventually a weak dollar and growth overseas should shrink the external deficit and reduce fears about debt.
If not, expect more financial instability and more creeping protectionism. Like it or not, the world remains highly dependent on US policies and institutions. Significant failures in the global system will likely do more harm to countries other than the US itself which has the capacity to be much more self-sufficient than is currently the case – and, in extremis, to default on foreign obligations. But meanwhile it will take more than clowns in Congress to turn the debt issue into a tragedy.
(Philip Bowring is a consultant editor and co-founder of Asia Sentinel. This first appeared in YaleGlobal, the on-magazine of the Yale Center for the Study of Globalization)