Earlier this year, many observers wondered why the cost of buying protection against the risk of default on the US government’s treasury bonds was as high as 50 basis points per year. Why would the US ever default on its debt? Could it not just employ its independent monetary policy and inflate away the problem? Well, it has turned out to be not that simple.
The US credit rating downgrade from AAA to AA+ by Standard and Poor’s and the political gridlock around the debt ceiling have made it clear that even when a country may be in a position to pay its debts, its creditors may not be in a position to ensure that it does so. Economists call this difference the “ability to pay” versus “willingness to pay”. Sovereign defaults are typically triggered due to a lack of willingness to pay when a country’s cost of servicing the debt gets out of hand relative to future sanctions from a default in debt markets and foreign trade. The US twist on the lack of willingness to pay is political risk—the risk that political parties catering to their respective vote-banks will fail to reach adequate compromise on the best way to continue paying creditors.
The short-term reaction to the actual downgrade was nothing short of a panic. Investors shunned risky assets, seeking safe havens in gold and government bonds. However, given the fragile financial condition of many large governments, especially in Europe, the safest haven was again the US treasuries (paradoxically therefore, US treasuries ended up being the best hedge against their own downgrade!). The risk of a double-dip recession in the US economy is rising, but all indicators suggest this won’t cause it to fall off the cliff. What may do so, however, is the mounting risk of further political gridlocks in dealing with the sluggish economy, and particularly, the government’s finances.
Not the real American economy yet, but its political economy is what appears to have crossed the Rubicon.
The root cause of all this appears to be the growing polarization of thinking on the side of the two political parties, both erring to the extremes in determining the role of government in the economy. So far, this has led to disastrous policy choices. What is the point of the government providing under-funded healthcare to the elderly at the risk of impoverishing future generations? What have the excessive housing subsidies— supposedly aimed at the poor—delivered in terms of economic growth other than a gross misallocation of resources? How could extraordinary expenditures such as wars—justified or otherwise—not be met through one-off tax increases so as to keep long-term budgets in balance?
Whichever way one looks at these policies—healthcare, housing, taxes—they seem to have delivered the lowest common denominator for the US economy, namely unsustainable promises and a mountain of long-term debt, while serving the private and short-run objectives of the two parties in pleasing their respective voters. Many talk about whether there will be a lost decade for the US. Few acknowledge that in many ways, a lost decade has already been witnessed due to these policies.
Going forward, there are bound to be greater calls for substantial restraint on government spending. The resulting fiscal austerity will involve difficult choices. Given the under-investments in public infrastructure and school education, some key drivers of long-run growth will likely remain begging for more funds. The shaving of economic growth this will bring about may itself render the US treasuries to give up their safest asset status at some point. On a positive note, the US does have several rich assets in the quality of its university education, an innovative and entrepreneurial culture, and a large number of multinational firms. These ought to be able to participate in the few global pockets of high growth and offer resistance to the overall economic decline. But it is unclear that this resistance can swiftly alleviate unemployment and rising poverty for the millions of Americans who are relatively low skilled.
It is this predicament of the US that is most worrisome. How will its population respond to the coming austerity? Will the youth rebel as they have in other parts of the world? Or will the rich soften this blow by yielding to higher taxes in the short run, realizing that this can lead to faster-growing income eventually than from keeping taxes low forever? Or will the polarization between the two groups keep rising and foster further political risk and downgrades of US treasuries? There are no clear answers, yet.
This week, my four-year-old son was flipping through the wonderful book John, Paul, George and Ben that introduces to children in a comical way the inspiring stories of US’ founding fathers. I heard him read: “Ben says: We must all hang together, or we shall all hang separately.” I realized that it is high time for the US to dig deep into its rich cultural roots. Benjamin Franklin’s exhortation at the signing of the Declaration of Independence in 1776—to focus on the common goal rather than individual interests—is exactly the leadership America needs from each and every citizen to free itself from the clutches of dysfunctional politics.
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Viral V Acharya is professor of finance at the New York University Stern School of Business