Sequestering Our Credit

Whether cheering for the slugger’s anabolic home run, splashing the youthful neurotoxic grin on magazine covers, or lauding the derivative-infused quarterly profit, we often support the short-term gain over longer-term welfare. The recent sequester debate is merely the latest manifestation of this cultural phenomenon. The sequester, a product of the 2011 debt-ceiling crisis, seeks to impose fiscal discipline on a deeply divided political system.  If politicians cannot craft a debt compromise today, it triggers a self-inflicted austerity of $85 billion (or 0.5 percent o GDP) in automatic spending cuts that range from defense to Medicare. Yet such artificially imposed deadlines are much better at producing political theater than addressing longer-term budget woes. Not only would these haphazard budget cuts threaten to slow the young recovery but they also spotlight the political system’s inability to forge a compromise between tax and entitlement reform. This hurts the United States’ long-term credit prospects by repeatedly clouding investors’ perceptions about the political will to meaningfully reform public finances.

Why do U.S. politicians exhibit such behavior? Why is achieving a policy consensus so difficult? In my recently released book, Globalization and Austerity Politics in Latin America, I find that two factors – one international and one domestic – tend to drive historically polarized countries toward economic reform. On the international level, when governments rely on global bond markets to finance their spending (as opposed to bank loans, foreign aid, or other revenue sources), they are more likely to choose austerity, or fiscal discipline, notwithstanding their partisan origins. Facing largely dispersed creditors, with little stake in their solvency, politicians gravitate toward the economic center to avoid catalyzing capital flight and a destabilizing shock. At the domestic level, the political legacy of economic crises can also blur traditional left-right ideological divisions. High economic volatility tends to increase risk-aversion among political leaders, opening the door to partisan compromise. In Latin America’s case, collective memories of painful, inflationary trauma unifies political elites around the common cause of battling inflation.

 

By extension, why hasn’t high foreign indebtedness and past volatility led to a consensus for economic reform in the United States?  Like steroids, Botox, or cheap credit, the country has an enabler: the global reserve currency system.  As the holder of the reserve currency, the United States can borrow heavily without incurring the same cost as other highly indebted countries.  Rather, its reserve currency status offers it a lucrative benefit: a low interest credit facility.

 

For the last decade, the United States has benefited from hefty demand for dollar assets from countries either looking for financial insurance against capital volatility or to boost their currencies’ competitiveness. What has been the product of this buying spree? The United States can borrow at low, long-term interest rates not seen since the end of World War II. The promise of such cheap funds creates a seemingly intractable political problem. Why reform the budget today, when you can delay the pain of fiscal adjustment until tomorrow? President Obama has encouraged Americans to reverse the “legacy of deficit spending” and “eat our peas,” but why would Washington politicians graze on greens when they have the golden ticket to the chocolate factory?

 

Many countries that have undergone financial crises have not had the safety net of such inexpensive financing. From East Asia to Latin America, for instance, past crises were often characterized by a fire sale of global investors’ assets.  These capital flows out of the country then translated into dramatically higher interest rates for governments, firms, and individuals that depressed investment and consumption, and gravely impaired recoveries. In the wake of these crises, governments faced a catch-22: they could enact austerity in hopes of re-attracting capital or instead risk intensifying the economic downturn. Not surprisingly, many countries chose austerity.

 

Suffering through such economic pain is a high price to pay for reform, but without this market disciplining mechanism, it may never occur. As home to the world’s safe-haven currency, the United States avoided a market-imposed austerity even during its own financial crisis. As the crisis rippled through the globe, international investors searching for a safe place to funnel their money required more dollars. Combined with the trillions of dollars needed daily to settle trade and investment transactions, the United States profited from unrelenting demand for its currency. Not only could it use low interest rates to ride out the recovery, but it could also use this buffer to address its fiscal woes incrementally. But, when does the asset of time turn into a liability?

 

Armed with the global reserve currency, U.S. politicians might surmise that their high-profile partisan clashes have little economic cost. Unlike Greece, they are not subject to the whims of short-term private capital or the onerous demands of international institutions.  Moreover, high demand for dollars is unlikely to abate in the near future, with the euro zone mired in crisis and China still a nascent competitor. But, creditors may divest from dollars if they feel their investment is not secure. The inability to cut a fiscal bargain even in the face of the sequester reflects political resolve – protecting entitlement programs, securing defense spending, or avoiding tax hikes for core constituents – but it also signals a lack of fiscal resolve to global investors.  Each time U.S. politicians impose and unsuccessfully meet an unrealistic deadline for fiscal reform, they tempt investors to diversify away from dollars.

 

How long will creditors continue to invest in low-yielding U.S. treasuries amid political gridlock and potential future credit downgrades?  To protect the quality of its reserve currency asset, the United States needs to enact far-sighted fiscal reforms. Avoiding the temptation to muddle through may prove difficult, and even politically costly. But, the inability to reform is economically costly, and may erode the country’s low-interest safety net. Today, there may be few competing safe-asset destinations globally but the U.S. is challenging the world to find one.  Ironically, it might take such capital flight, and an even deeper crisis, to catalyze political compromise.

 

 

 

 

 

 

5 Responses to Sequestering Our Credit

  1. Andrew Gelman March 1, 2013 at 12:39 pm #

    Stephen:

    I’m no expert in this topic and am not disputing your larger analysis, but I’m skeptical of your association of the sequester with the idea that “we often support the short-term gain over longer-term welfare.” My casual impression (from reading the newspapers) is that nobody really wants the sequester—that is, there is no “we” that is supporting this policy. Rather, it is an effect of political gridlock. So I think you might be making the error of attributing individual volition to what is in fact a system with many moving parts.

    • Scott Monje March 1, 2013 at 12:57 pm #

      If you prioritize the possible outcomes as you would in a chicken game, you could say that the sequester was no one’s preferred outcome in the sense of it’s being the No. 1 priority, but each side preferred it to giving in to the other side’s No. 1 priority. Thus, in the end, each side preferred inaction to compromise on a solution. (One or both sides may also see this outcome as setting up a favorable position in the runup to the Continuing Resolution deadline coming in three weeks’ time.)

  2. Stephen March 1, 2013 at 1:19 pm #

    Thank you for your comments, Andrew. I wouldn’t dispute that there are many moving parts here, but I do think (as highlighted by Scott) that the sequester reflects that each side preferred inaction to compromise. Such repeated public stalemates, however, do have a longer-term economic cost that I think politicians are overlooking.

  3. Adam March 4, 2013 at 11:14 am #

    This might be completely ridiculous (please let me know if it is), but what if the sequester was Congress’s way of showing it could cut spending? I thought everyone knew the super committee would fail (I didn’t think it would work and that’s the sense I got from everyone on this blog), and thus, their vote for the super committee was really just a vote for the sequester, but no one could openly vote for the cuts since they hit programs favored by people on both sides of the aisle.

    I kind of thought that they ingeniously set it up so that the cuts couldn’t easily be undone (solving the time inconsistency problem that always looms large over any “long-term deficit reduction plan”) while giving each party and individual member plenty of opportunities to avoid blame for how things panned out and yet credibly blame the other party. Here’s Congressman [FILL IN THE BLANK]’s response to an upset constituent or to a news story about the defense contractor in his district that gets shut down: “I didn’t vote for this. It’s the [INSERT OTHER PARTY]’s fault that the super committee failed and your favored program got cut. The [INSERT OTHER PARTY] is uncompromising in their desire to [let the rich pay low taxes / tax America to death].”

    The problem is that they did too good of a job of convincing everyone that they really thought the super committee would succeed or that the poison pill of the sequester would force compromise. And now the politics surrounding the sequester have overshadowed the substance of what Congress accomplished–making cuts in a highly partisan, divided government to a broad spectrum of programs that both parties would rather not cut.

    I realize a lot of this doesn’t line up with what people involved in all of these deals have said about the budget deal, but again, they’re in “avoid blame” right now, so I’m not sure what to make of it. Plus, I just can’t get over the fact that it seemed obvious to almost every observer that the super committee would fail, so why didn’t the members of Congress see that, too, when they voted on the debt deal? Were they really banking on compromise further down the road, or just holding out to see what would happen in the 2012 elections? But even then, why include the sequester in the deal? They knew that there would be another deficit ceiling debate after the election that could be used to force a deal of some sort, so why throw the sequester in, too?

  4. Joel March 5, 2013 at 3:01 pm #

    “And now the politics surrounding the sequester have overshadowed the substance of what Congress accomplished–making cuts in a highly partisan, divided government to a broad spectrum of programs that both parties would rather not cut.”

    i think this says mouthful. if your silver lining is something that nobody wants, how “ingenious” can it be?