The recent 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 being responsible for default. The dollar has weakened, but there has been no mass flight from US bonds or a repeat of the 2008 contagion. Those who want to flee US bonds have few places to go other than speculations like gold. But meanwhile the United States 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.
The most immediate 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 have seldom been taken to the point of seriously damaging the US position in the world, but the debt issue is also a key part of foreign policy and underlies treaties such as NATO. In the past, America’s friends and 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.
There have been many times when Congress has thwarted the executive’s policies, 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 United States. The influence of the US overseas has already been eroded by its domestic politics, but the debt issue simply staggered the world as we saw that lawmakers can put the US reputation at such risk over sums of budget money almost irrelevant to the longer term stabilization of debt.
Debt is indeed a serious long-term problem even without extrapolating this year’s peak of just under 10 percent of GDP into the future. But what immediately strikes many foreigners as barely comprehensible is the massive resistance to taxes, even though the United States is lowly taxed by most developed country standards. Resistance to ending tax breaks for favored sectors among those who purport to believe in free markets is even more bizarre.
So how bad is the overall deficit problem? It is little more than a decade since, under former President Bill Clinton, the US government was in surplus. Subsequent factors included the cost of the post-9/11 wars, tax cuts under George W. Bush, now extended, bailouts of financial institutions following the 2008 crisis and shrinkage in revenues.
Now, the United States needs to perpetuate government deficits to sustain modest economic growth because overstretched consumers are retrenching and corporations are 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.
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.
Here is a third problem. Japan’s government debt is 70 percent more than that of the United States as a percentage of GDP and its demographic outlook is far worse. So why are people 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 United States has been able to finance its excess consumption because of the reserve currency role of the dollar and the zeal of central banks to keep their currencies depressed and trade surpluses high by buying US debt.
The debt issue may yet remind 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 creeping protectionism.
Like it or not, the world remains highly dependent on US policies and institutions.
Philip Bowring is a Hong Kong–based columnist and a former editor of the Far Eastern Economic Review.