Sequestering Our Credit

Mar 1 '13

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.