Saturday 24 Oct 2020 | 23:40 | SYDNEY
Saturday 24 Oct 2020 | 23:40 | SYDNEY

US debt talks: Who will blink?


Stephen Grenville

18 July 2011 15:08

If the US Congress doesn't agree to raise the limit on US debt by 2 August, government expenditures will have to be cut to match revenue, involving a 40% cut in spending. This would not mean a default on US debt (interest payments would still be met), but financial markets would be shocked.

Fed Chairman Ben Bernanke described this possibility as 'calamitous' and 'a self-inflicted wound'.

All the focus is on this largely political aspect of fiscal policy, but this is a distraction from the important economic issues. What Washington needs is a continuation (or even expansion) of short-term budget stimulus to shore up an economy with feeble growth and 9.2% unemployment. It also needs a firm commitment to a credible long-term plan to reduce the deficit and hence stop the debt from drifting inexorably upwards.

Failure to raise the limit would do just the opposite: immediately curtail necessary cyclical support without providing any plan for the necessary longer-term structural changes. The current budget position would worsen because interest rates on government debt would rise.

Of course the debt limit is just a political bargaining game. It is in no-one's interests to trigger the catastrophe. But Democrats and Republicans alike will take this up to the wire to see who blinks first on the content of the budget changes that will be the quid pro quo of approval.

Within each political party there are serious divisions. On the Democrat side, Obama is prepared to prioritise expenditure cutting rather than tax increases, to the dismay of many traditional Democrat supporters. On the Republican side, the Tea Party is single-minded in its opposition to any notion of tax increases, while traditional Republicans largely accept that the fall in tax-to-GDP ratio in recent years cannot sustain even a minimalist small-government administration.

In this game of chicken, neither side wants to risk the blame for failure. But the US political process sometimes seems to have a life of its own, and accidents can happen.

If there was any real prospect that the debt limit will not be raised, the nervous nellies and drama queens of the financial markets (more kindly called 'bond market vigilantes') would be pushing up government bond yields, especially as the Fed's QE2 bond purchases have ended (with little effect, as predicted here).

The important issue is whether the President can use this game of bluff to achieve an outcome that serves both long and short-term needs. A messy compromise which left the longer-term issues unresolved until after the next Presidential election in 2012 might leave bond markets hostage to later adverse change in sentiment. Recent warnings by the two major credit rating agencies have made this more likely, with one of them putting a 50% probability on a down-grade in the next three months.

A longer-term fix is feasible, but will be hard work.

As recently as 2001, the last Clinton budget was in surplus. Two wars and the Global Financial Crisis have changed the position. The Congressional Budget Office base-case forecasts of a reduction in the deficit from 7% of GDP next year to 3% in 2014 are predicated on ending GFC-related stimulus measures such as payroll tax reductions and unemployment benefit extension. But with the economy likely to remain weak, it would be inappropriate to end these programs any time soon. Thus the deficit will stay large until the economy improves. 

Even if the US can get beyond the cyclical drag on revenue, demographic changes are looming which will push up entitlement expenditures. The CBO has scenarios which would take debt/GDP from its current 62% to 190% by 2035. 

In the meantime, there is a heated debate on the short-term effect of fiscal tightening. Some (including, sometimes, the President) argue that tighter fiscal policies, even in the short term, will stimulate the economy. For House Speaker John Boehner, the answer is to stop 'job-killing government expenditures'. Others, reflecting the middle ground of economic opinion, have little faith in the 'Confidence Fairy' and see no evidence that government expenditures are 'crowding out' private-sector spending in such a weak economy, or that the deficit is discouraging private expenditures by pushing up interest rates.

Photo by Flickr user Caro's Lines.