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Government Finance

Trying to Play Chicken with Everybody’s Money

A slow and painful battle over America's financial future, photo: Benjamin Reed/flickr

The bumbling US Tea Party has issued its latest ultimatum: cut public expenditures or risk defaulting on the national debt. And how? By stopping lawmakers from raising the country’s legal debt ceiling, currently set at $14.3 trillion. The US Treasury reckons it will hit and inevitably exceed the limit sometime between late March and May.

The Obama White House has deemed the issue non-negotiable. Is it an idle threat?

Strictly speaking, the Tea Party doesn’t have the votes in Congress. Mainstream Republicans would all have to vote no. Mainstream Republicans, however, primarily serve the interests of the corporate and financial elite; overt attempts to undermine US economic power typically receive a cold reception with this crowd.

As discussed in my ISN Blog post last week, the instance of disagreement nevertheless puts the spotlight on the growing rift in the American Right. It also exposes the ignorance of the frustrated Tea Partiers. Nuking your economy is no solution to your economic woes.

Ask Americans what specific spending cuts they prefer and almost unanimously they respond that Social Security and Medicare (the national pension scheme and healthcare for the elderly) are off-limits. Non-defense discretionary spending, about $650 billion, is a perennial favorite for the axing but too small to rectify America’s fiscal quandary. Defense spending is ultimately the one thrown under the bus, but few politicians would ever get caught dead saying so.

In the end, broad and balanced reforms on both the revenue and spending sides will be necessary. To date, mainstream Republicans have promised $100 billion in cuts and come up with a paltry $32 billion. The Tea Party, again, proposes nuking the economy to force spending cuts.

Washington defaulting on its debt would indeed be catastrophic. Leading US policymakers’ takes here, here and here. To start, as Reinhart and Rogoff meticulously detail in their must-read book This Time is Different: Eight Centuries of Financial Folly, the US, unlike most other sovereigns, can be considered a ‘default virgin;’ it has almost effectively never defaulted on its debt in its 235-year history. US Treasury debt and those of it agencies (primarily Fannie Mae and Freddie Mac) are the largest, most liquid financial asset class in the world.

The US, moreover, is the steward of the world’s monetary system: the US Dollar system. It serves alongside the military and foreign assistance as the bedrock of US hegemony. Two thirds of all central bank reserves the world-over are held in Dollars or Dollar-denominated securities. The lion’s share of today’s cross-border trade and transactions are denominated and settled in Dollars.

As University of California, Berkeley Professor Barry Eichengreen argues, this ‘exorbitant privilege’ – which allows the US to live beyond its means because the world’s demand for Dollars permits it to pay interest rates on its foreign liabilities typically two to three percentage points lower than the rate of return on its foreign investments per year, licensing it to run persistent current account deficits of this size with foreign countries without becoming more indebted – has held since WWII. Within the next 10 to 30 years, however, the advantage will most likely dissipate, resulting in a multipolar global monetary system. The Euro, which increasingly looks as though it will survive its recent travails, is available and growing in its attraction as an alternative to the Dollar. The transition need not be abrupt or dramatic.

Significant economic mismanagement in Washington, however, Eichengreen cautions, could bring about a Dollar crash. Precipitating a debt default certainly qualifies as such. Failing to adopt a credible medium- to long-term strategy to bring US debt under control qualifies equally if not more so.

The Tea Party should expend its energies affecting change in the latter category, where its middle-class economic interests lie, rather than in the farcical former.

For more information, check out: The Cost of America’s Free Lunch, by Daniel Gros.

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