US Budget and Debt-Ceiling Impasse: Three Scenarios for the World Economy
by Dennis Snower
The United States have entered a critical week for resolving the budget and debt-ceiling impasse. There are three possible scenarios of what might happen: The worst-case scenario is that the US government defaults on its debt, which I consider to be extremely unlikely. The implications of this scenario would be very serious and far-reaching for the world economy. The main reason is that US Treasuries are used as collateral for many loans, since they have thus far been regarded as very safe and liquid assets. In particular, more than 30% of the collateral that financial institutions use to borrow in the “tri-party repo” market (a source of overnight funding for banks, among other institutions) are in the form of US Treasuries. If, as result of a US government default, lenders required different collateral or more US Treasuries as collateral for the same loans, there could be a global financial meltdown.
The intermediate scenario is that for Democrats and Republicans step back from the brink and make a deal on the budget that prevents default, but keeps the prospect of US government solvency in a state of uncertainty. This I consider to be the most likely scenario. In that event, it is likely that the problem will be put to sleep, ready to awake at a later date in a more serious form. The longer-term consequences of this scenario is that lenders gradually begin to perceive US Treasuries to be more risky than heretofore and therefore gradually dim and more US Treasuries as collateral for a given amount of loans. The gradualness of this development would permit global financial markets to adjust in an orderly fashion, but the longer-term consequences would still be serious, both for the United States and for the other countries participating in global financial markets. The reason is that this development would have an analogous effect on financial markets as the gradual rise in world interest rates. Given the current fragility of financial markets and a high level of indebtedness of some countries and some large financial institutions, such a rise could eventually turn out to be destabilising for the world economy.
It would also lead to the gradual decline of the US dollar as reserve currency. It is on account of the dollar’s reserve currency status that the US is able to run persistent current-account deficits (for example, importing more than it exports), since that is the way for dollars to flow into the hands of other countries. In short, the US is permitted to live beyond its means and, in return, it provides liquidity for international financial dealings and international trade. The gradual decline of the US dollar’s reserve currency would erode this huge privilege that the United States enjoys.
The third scenario, which I consider to be very unlikely, is that though Democrats and Republicans solve the US budgetary problem by adopting a sustainable fiscal rule. Such a rule would specify a long-term ratio of national debt to GDP, the rate of convergence to this debt ratio, and the counter-cyclicality of fiscal policy. Since the long-term ratio of national debt to GDP is a constant, the national debt would be allowed to rise but not faster than aggregate economic activity. The ability to pursue counter-cyclical fiscal policy would mean that deficits could be run in times of economic fragility, counterbalanced by corresponding surpluses in times of boom. This would enable the US government to stabilise recessions while at the same time avoiding problems of financing the government debt. If Democrats and Republicans would argue over the appropriate formulation of the fiscal rule, then voters could determine how much national debt should be carried forward to the future, which is an issue that the democratic process should be allowed to decide.