Wednesday 16 October 2013

Unbalanced budget, overbalanced politics?

Even if the United States manages to avert a debt default this time, its steep debt pile and flawed debt ceiling approval process all but guarantees a similar crisis will occur again
By Fiona Chan, The Straits Times, 15 Oct 2013

IT HAS been billed as the worst financial disaster in the making since investment bank Lehman Brothers collapsed five years ago.

And even as the US scrambles to avoid the catastrophe of breaching its debt ceiling, the nightmare that the world's top economy might run out of borrowed money is likely to keep recurring, until it fixes either its finances or its politics.

Over the last week, the world has watched in fascination and fear as US lawmakers, locked in a bitter fight over a controversial health-care law, held the economy hostage. House Republican leaders refused to approve the government's spending for the year starting Oct 1 and said they would also prohibit the government from borrowing the money it needs to pay its bills, unless their demands to delay the health-care law are met.

The US Treasury estimates it will hit its current credit limit of US$16.7 trillion (S$20.8 trillion) on Thursday, leaving it with funds only from cash on hand and tax revenues. If it is not allowed to borrow more, the US is expected to run out of cash around end-October and would have to slash spending just as large bills are due, including US$6 billion in debt interest payments and about US$60 billion in health-care and benefit payments.

A default on US debt could lead to global financial mayhem.

US bonds, or Treasuries, are considered "risk-free" by markets and held in large quantities by many governments, such as China, Japan and Singapore, and investors. The yields on the bonds - the returns investors demand in return for holding them - are also used to benchmark a range of financial assets. If the US defaulted on its bonds, their prices would plunge and their yields would shoot up, causing market chaos.

The real economy would also be hurt. Without the ability to borrow more, the US must cut spending, at the expense of economic growth and jobs. It would slump into recession, with the rest of the world not far behind - including Singapore, which counts the US among its top export markets.

Deeply in debt

WELL aware of the severity of such a scenario, world leaders have been urging the US to quickly resolve its infighting.

But even if the lawmakers get their act together in time to raise the debt ceiling now, the crisis is likely to repeat itself when the US reaches its new debt limit again.

At the root of the problem are two fundamental issues: the US' unbalanced budget, and its perhaps overly balanced government.

The former holds the US economy in thrall to debt, and the latter takes advantage of this addiction.

Let's look at the finances first.

Of the 65 years between 1948 and last year, the US government outspent its revenue 58 times and ran a surplus in only seven years, the last time being in 2001.

It has borrowed heavily, mainly by issuing bonds, to make up the difference: its total debt last year exceeded the US economy's annual output for the first time.

Despite the sub-optimal fiscal situation, US assets are still regarded as ultra-safe because of the government's prompt payments so far, the size of its economy and its supposed ability to print as much money as it needs.

But markets' confidence may not last forever. After the last debt ceiling crisis in 2011, credit rating agency Standard & Poor's downgraded its top rating of US debt for the first time in history.

This reflected its concerns that the US had not done enough to reduce its debt burdens, especially its mandatory spending on "entitlements": social welfare and national health insurance schemes.

As the population ages, entitlement spending will double as a share of the economy between 2010 and 2050, says think-tank Heritage Foundation. Along with other economic watchers, it has warned that the US budget is on an "unsustainable course" without reforms to reduce entitlements and streamline taxes.

With this latest debt drama, markets are again re-evaluating the soundness of US finances. Investors last week sold off short- term US bonds, pushing their yields higher than US interbank rates for the first time ever.

In other words, US banks could borrow from one another at lower rates than the US government could borrow from investors, reflecting the view that "US government finances are in worse shape than US banks", said ABN Amro economists Georgette Boele and Peter de Bruin.

One bright spot is that the US' deficits have been slowly shrinking since its last recession ended in 2009, and its finances are set to improve further after a raft of spending cuts kicked in this year.

But more urgent work is needed to repair the US budget and reduce its reliance on debt. If not, the Treasury's never-ending need to raise its debt ceiling could gnaw at investors' nerves, a constant reminder that the world's supposedly safest economy is also its largest debtor.

Laws and politics

THIS is especially since the lawmakers who must agree to increase the debt limit have become increasingly reluctant to do so without extracting political concessions in return, making each debt ceiling encounter an exercise in tension.

Citi economists Robert DiClemente and William Lee noted that this ongoing impasse adds to the US' "dubious track record" of 18 government shutdowns and eight previous debt ceiling stand-offs since 1974. While they view a debt default as unlikely, what is "more worrisome is the chronic dysfunction in the policy decision-making process that these developments reveal", they said.

"With larger structural deficits only a few years away and the public debt burden already very high, the inability to make timely policy choices may provide the last ingredient in a potentially toxic brew," they added.

Underlying the fractious politics is a twofold problem in the debt ceiling structure.

First, any rise in the debt ceiling must be approved by both Houses of Congress. When each is led by a different political party, as is the case now - the House of Representatives by Republicans and the Senate by Democrats - there arises an irresistible opportunity for either to use debt ceiling talks as leverage to achieve some other political end.

The situation is exacerbated by the increasing polarisation of politics in the US, with ideological splits surfacing not just between Democrats and Republicans but also between Republican moderates and Republican hardliners. The latter group seem particularly unconcerned that extracting their pound of flesh could come at the expense of the US breaching its debt ceiling, with some even dismissing as alarmist warnings about the repercussions of such a move.

Second, while Congress must agree to both the government's spending plan and its debt ceiling, the decisions are made separately.

This effectively means Congress can approve the government's budget while withholding the funds needed to implement it - an unnecessary two-step process that merely increases the opportunities for a stand-off.

Several suggestions have been tabled to work around the debt ceiling gridlocks. One is to reintroduce the Gephardt rule, devised by former House leader and Democrat Richard Gephardt in 1979, which provided for an automatic debt ceiling increase upon approving the budget.

When Republicans took back the House in 1995, they waived this rule so as to have more negotiating leeway. That year, the US government shut down twice.

Other proposals include having President Barack Obama unilaterally raise the debt ceiling by invoking the 14th Amendment in the Constitution, which says the validity of US public debt should not be called into question; and minting a trillion-dollar coin that the US can use to technically offset some of its current debt, buying itself more borrowing headroom. But both these suggestions have been dismissed as risky and potentially illegal.

Meanwhile, each drawn-out fight over the debt ceiling reduces the US' credibility not just as a safe haven but as a dominant economic and political force. Without a serious effort to improve its debt or political situations, the US may well be headed for a series of escalating debt ceiling crises - and an eventual corresponding loss of confidence from markets.

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