The Downgrade: Imagined Lines Are Not Imaginary

This is a guest post by James Vreeland of the School of Foreign Service and Department of Government at Georgetown:

If we had raised the debt limit with no fanfare, like usual, it would have had no effect – it’s just an arbitrary line.

But if you treat it like a line in the sand, drawing the attention of the world to our unsustainable fiscal situation, and then you fail to cut much spending or raise taxes, you send a powerful coordinating signal to the global herd: It’s time to run.

See, our twin deficits – fiscal and current account – are sustainable only as long as people believe they are. But if people stop believing, then they will start to run from the dollar and from US bonds. If that happens, you don’t want to be the last one left at the party.

Now, we all know that US imbalances are unsustainable. The only question is just how far they can be pushed, and what exactly triggers them to come back towards balance. I have been hoping that they might someday be addressed by China addressing their exchange rate as their economy develops. For a long time, China has benefited from a weak exchange rate against the dollar, as the United States is the main destination of their powerful export sector. But there is another pressure on the rise: competition for scarce resources. At some point, the Chinese government will see that the marginal benefit for the export sector from a weak exchange rate has met the marginal benefit from a strong exchange rate for cheaper oil.

If this day had come before the current mess, then we might have had nice market forces addressing US imbalances – and it would have been a slow and steady soft landing. With the revaluation of the renminbi, US consumers would be able to afford fewer exports from China, and the Chinese would buy more from the United States. A market solution would be nice because domestic politics on both sides of the border were not going to address this. Certainly not the “non-tax and spend” Congress. Our government simply lacked the political will to do what was necessary.

But, dammit, the last thing you want to do is to call attention to the lack of political will! Changing the debt ceiling issue into a global focal point forced Congress to finally put up or shut up. They failed to put up. The way you address a fiscal deficit is to cut spending and raise taxes. Every country that has been subject to IMF austerity knows this all too well. In their arrogance, (some members of ) Congress believed the United States is above this logic. Now we’re heading for no man’s land. We have announced to the global herd in a focused manner that the United States lacks the political will to address its deficit. Sadly, this is going to hurt global economic transactions, which many people believe contribute to a more peaceful world. The foolishness of making the debt ceiling a focal point – especially with what is going on in Europe – cannot be underestimated. Hard times are ahead.

2 Responses to The Downgrade: Imagined Lines Are Not Imaginary

  1. OneEyedMan August 6, 2011 at 2:25 pm #

    I’m not convinced that the Yuan is undervalued. A recent article in the Economist says “…the yuan now appears to be close to its fair value against the dollar”
    http://www.economist.com/blogs/dailychart/2011/07/big-mac-index

    There doesn’t seem to be any indication that the global herd is running either.
    Yield curves are uniformly down from before the debt ceiling talk. http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2011
    That’s not what I would expect from a global herd expecting end to American ability to borrow. If it were just the panic holding things down, w’d expect the long end of the curve have a higher yield even as the short end traded tighter.

  2. B.D. Jones August 7, 2011 at 2:22 pm #

    Great point on attention to ‘political will’. I hear all the politicians, for some reason especially Democrats, howling about the S&P downgrade, comparing it to their 2008 debacle. BUT here is a rating agency getting AHEAD of the curve–being willing to take the grief for building management issues into the rating. This is exactly how they should have behaved in the run-up to 2008.