Debate: US debt ceiling

Updated: 2011-08-01 08:20

(China Daily)

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What lies in store for the rest of the world as rival US politicians fight over raising the federal government's debt ceiling? Two experts enlighten us with their views.

Yao Yang

Obama paying for his presidency

American politics is facing a political showdown. If Congress and the White House cannot reach a compromise to raise the debt ceiling by Aug 2, the federal government will have to either shut down part of its operations or default on some of its debts. Shockwaves will debilitate the markets in either case, and the global economy's fragile recovery will probably be reversed, and another recession could follow.

Because of these dire consequences, it is highly unlikely that Congress and the White House will fail to reach an agreement by Aug 2, unless hardliners in the Republican camp are crazy enough to trade the country's fate for President Barack Obama's scalp.

Most people believe that a short-term agreement is likely to be reached between the Republicans and Democrats to raise the debt ceiling for a short period, say by three months. But the debt issue is a hostage that Republicans are using to undermine Obama's re-election bid.

If the Republicans do use the debt ceiling to thwart Obama's re-election bid, they will throw the entire global economy into deep uncertainty for the next 16 months. The unemployment rate in the US is still above 9 percent, and the uncertainty caused will further discourage companies to recruit more people. The sluggish recovery in the US will drag down economic growth across the world.

Worse, to boost the confidence of the business world, the US Federal Reserve (Fed) is likely to announce a third round of quantitative easing (or QE3), which will force emerging markets to face even greater pressures of inflation and currency revaluation.

From the day he was sworn in as US president, Obama has wanted to be a centralist. In terms of his economic policy to deal with recession, he has been swinging between the more liberal Keynesian economics and the more conservative supply-side economics. The stimulus plan he signed into law shortly after entering the White House was devised under the George W. Bush administration. It was not directed at creating jobs so much as at providing a tax holiday for corporations and the rich. Later, when the Republicans gained control of the House of Representatives, Obama was forced to extend the Bush tax-cut plan. His call to double US exports in five years has been more political rhetoric than a call for real action.

In the end, the US economic stimulus plan has become a problem, rather than a solution for recession. The high unemployment rate is forcing the federal government to extend its relief spending. But federal tax revenues do not increase because of tax cuts. The result, of course, is large federal deficits.

To encourage business expansion, the Fed has lowered the real interest rate to below zero and increased money supply in QE1and QE2. But the response of the business sector has been weak. This is not because the business sector is still in a bad shape; it is actually doing quite well.

In 2009, the unit product labor cost in the US' manufacturing sector dropped 17.2 percent, and in 2010 it fell by a further 3.9 percent. That means US companies are producing more goods using less labor. And this is the real secret behind the jobless growth.

At present, the key to reducing the federal deficit is to increase employment. The irony is, that to do so, the federal government has to temporarily increase spending. But since the majority of the unemployed workers have low levels of education and many of them have been laid off by the construction sector, a sensible way of re-employing them would be to start public projects in infrastructure. Given the current deadlock over the debt ceiling, however, this is not likely to happen.

American history shows that only Franklin D. Roosevelt has been re-elected as president when the unemployment rate was higher than 8 percent. So Obama has every reason to worry about his re-election bid next year. But the Republicans know their history, too, and that is why they will not agree to the Democrats' proposal to have an agreement that extends beyond the presidential election even though the proposal is a wholesale surrender to the Republicans' demand for spending cuts.

Seen from a longer-term perspective, the Republicans seem to have a point: federal spending on Medicare and Medicaid is not sustainable in their current forms. But cutting these two programs will hurt millions of Americans and will be an unpopular move regardless of who carries it out.

The experience of other countries tells us that the two programs alone may not be the cause for the rising budget deficits. Great Britain and Canada both have free universal health coverage, but their expenditure on healthcare is controlled within in a reasonable range.

The key difference is that in Great Britain and Canada, medical services are financed as well as provided by the government, whereas in the US the government is responsible for spending but relies on private companies to provide the services. As a result, private providers have reasons to overspend and the government is left with no effective way to control it.

Therefore, the American deficit problem is ultimately the result of the conundrum of a welfare state following the capitalist system. Both are uncompromising ideals cherished by a substantial percentage of the population. The fight will resurface in the future even if the present deadlock is broken.

There is a lesson for other countries here. The best a country can do is to fence off the contagious effects of such fights and rely more on the domestic economy for further growth.

The author is a professor at and director of the China Center for Economic Research at Peking University.

Mohamed A. El-Erian

US politicians imperil economy

It has been raised more than 70 times in the last 50 years, mostly without commotion. It must be raised again this summer if the United States government is to continue paying its bills on time. But now, the US' debt ceiling has become the subject of intense political posturing and touch-and-go negotiations behind closed doors. And, obviously, the outcome has implications that go well beyond the US.

As part of America's system of checks and balances, Congress gets to do more than just approve the annual federal budget. It sets a limit on how much debt the US Treasury is allowed to issue, too. Beyond this ceiling, the government can spend only from current revenues.

US Treasury Secretary Timothy Geithner recently informed members of Congress that the government will be in this situation on or around Aug 2. Having already officially hit the ceiling, the Treasury is moving money around and tapping various pots of unused funds to pay its bills. In a few weeks, this "flexibility" will be used up. With the US government now borrowing about 40 percent of every dollar it spends, a truly binding debt ceiling would immediately force the government to reduce spending radically and in a disorderly fashion.

Politicians across the political spectrum know that such a situation would unsettle an already fragile US economy, severely weaken the dollar, and raise serious concerns about the country's ability to meet its debt-service obligations, including to the many foreign creditors that the US will need in the future. Yet, in today's polarized environment in Washington, Republicans and Democrats are unwilling to compromise - or at least to compromise "too early".

By holding out, Republicans wish to force President Barack Obama's administration into massive spending cuts. Democrats respond that such a one-sided approach would be economically harmful and socially unjust. In the meantime, both sides risk disrupting transfer payments (including to the elderly) and the provision of public services, as well as eroding further the US' global credit standing.

The overwhelming - and sensible - expectation is that the Republicans and Democrats will compromise and raise the debt ceiling before inflicting serious economic and financial dislocations. The most recent precedent was the bipartisan agreement reached earlier this year on another fiscal issue that threatened to disrupt the normal functioning of government: the absence of a formally approved budget for this year.

A compromise would allow both parties to declare partial victory, for it is likely to entail commitments to cut spending and some steps to make taxation more socially just. But, like many last-minute agreements, it will have little durable impact. In effect, the political system will again be kicking the can down the road, with real progress on necessary fiscal reforms expected only after the November 2012 presidential election.

Two scenarios for the timing of an interim compromise are possible, depending on whether it is a one- or two-step process. Most observers expect a one-step process for bipartisan agreement before Aug 2. But politicians may need two steps: an initial failure to agree, and then a quick deal in response to the resulting financial-market convulsions. In the meantime, the Treasury would temporarily re-prioritize and slow outgoing payments.

This two-step process would be similar to what happened in 2008, when Congress was confronted with another cliffhanger: the George W. Bush administration's request for $700 billion to prevent a financial-market collapse and economic depression. Congress initially rejected the measure, but a dramatic 770-point drop in the stock market drove politicians back to the table - and to an agreement.

But the two-step scenario involves incremental risks to the US economy, and to its standing in the global system. And the longer America's politicians take to resolve the debt-ceiling issue, the greater the risk of an inadvertent accident.

This brings us to a third, and even more unsettling possibility: a longer and more protracted negotiation, resulting in greater disruptions to government entitlement payments, other contractual obligations, and public services. Creditors would then ask many more questions before adding to their already-considerable holdings of US government debt, generating still more head winds in a US economy that already faces an unemployment crisis and uneven growth.

The next few weeks will provide plenty of political drama. The baseline expectation, albeit subject to risk, is that Democrats and Republicans will find a way to avoid disruptions that would damage the fragile US economy, but that the compromise will not meaningfully address the need for sensible medium-term fiscal reforms.

Such political paralysis on key economic issues is increasingly unsettling for the US private sector, and for other countries that rely on a strong US at the core of the global economy. This helps to explain why so many companies continue to hoard cash, rather than invest domestically, and why a growing number of countries want to diversify gradually away from dependence on the dollar as the reserve currency and on the US financial market for intermediation of their hard-earned savings.

The world economy is hard-wired to the assumption of a strong US, and Americans benefit from this. But the more US politicians argue over the debt ceiling, the greater the risk of that wiring becoming irreparably frayed.

The author is CEO and co-CIO of PIMCO, and author of When Markets Collide.

Project Syndicate

Debate: US debt ceiling

(China Daily 08/01/2011 page9)