Self-inflicted wounds can be embarrassing, especially when suffered in public. But the follies in October of the US Congress over the federal government debt ceiling and budget sequester are more than that. They have damaged the US economic recovery, and they have done lasting damage to financial stability and negotiating power. The whole breakdown was completely avoidable in economic terms, which if anything increases the reputational damage.
There is no other example of a solvent democracy flirting with default through sheer political stubbornness. While many democracies with fragmented party systems have spent themselves into crashes—think of Italy in the 1970s or Argentina repeatedly—the crashes came only when they had run out of credit. On the fundamentals, the US government is perfectly capable of rolling over its debt at historically low interest rates, and the dollar remains strong. As many of us forecast, the federal deficit is shrinking rapidly on the basis of even the anemic economic recovery. So the United States' debt-to-GDP ratio is on a downwards trajectory.
Yet a group of radical right-wing Republican members of the House of Representatives threatened to have the United States technically default on its debt, and the Republican congressional leadership lost all party discipline. Worse, this totally voluntary disruption of the US economy and world markets is likely to recur at intervals until the composition of the House changes. That is unlikely in the midterm elections of 2014, more probably in the presidential election year of 2016, but possibly not until the next census and redistricting (redrawing electoral district boundaries) is completed in 2022. The dysfunctionality of US fiscal policy has become an ongoing reality.
The direct costs of these follies are already substantial. The sequester of federal spending that stemmed from an inability to agree to a deal earlier this summer reduced real GDP growth by 0.75 percent in 2013. The government shutdown in October cost another 0.3 percent. And the arbitrary manner of the cuts hit government functions in as backwards a fashion as possible, cutting public investment and high-impact services for the poor, maximizing the immediate damage.
The ongoing uncertainty about US budgetary decision-making, and the recurrent risk of a repeat, is now dragging down corporate investment. Companies were already sitting on unprecedented amounts of cash, reluctant to take risks after the crisis for a variety of reasons, both good and bad. The House's follies have sharply diminished the recovery of capital expenditure that was forecast for late 2013 and 2014. That will further limit growth both in the near term and productivity in the long term. For all the talk about business uncertainty arising from Federal Reserve policies, the impact of ongoing fiscal policy volatility on foregone investment will be much higher.
Worse still, global markets are now taking into account a default risk on US treasuries, where there had been none before. Whether this is permanent is unclear, but it is new ground. While very small, this risk premium represents a profound change. The majority of financial contracts that were written to treat US treasuries as the ultimate safe collateral and means of settlement now have to be redone to allow for some divergence between AAA rated investments and treasuries, if only temporarily. That imposes a need for investors to counterbalance the risk, raising the cost of all transactions. US taxpayers will, on average, be paying that premium on all newly issued US government debt from now on.
The most overlooked and perhaps most lastingly harmful effect of these follies will be the diminished ability of the United States to conclude international economic negotiations. Until now, the US government went into economic discussions, whether trade negotiations, G-20 summits, or IMF debt program discussions, with three strong cards: the ability to set the initial agenda, the financial strength to hold the line when there were disputes, and the credible tactic of demanding a good deal lest Congress object. All of those are now diminished. At the IMF–World Bank and G-7 meetings a few weeks ago, the first agenda item was criticizing the United States (deservedly) and nothing else got tackled. The Obama administration's ambitious trade agenda of concluding Trans-Pacific and Trans-Atlantic partnerships is stalling because negotiating partners rightly doubt the ability of the US government to gain congressional approval.
Some adjustment of US economic dominance is inevitable, as its size and income level shrinks relative to the rest of the world. An unintended acceleration of that process through domestic political failure, however, serves no one's interests—least of all the United States. Unquestionably, this entirely self-inflicted wound is speeding up American decline as well as undermining economic recovery.