Debt deal set to pass but what were the costs?

WASHINGTON/SINGAPORE Tue Aug 2, 2011 8:21am EDT

WASHINGTON/SINGAPORE (Reuters) - While the immediate crisis over a threatened default seems to have been averted by the eleventh-hour deal between the White House and Congress, the debt-limit drama has left behind crucial questions about the American political process, the viability of economic policy options and implications for the rest of the world.

The long, tortured debate exposed toxic partisanship and legislative dysfunction in Washington just when judicious efforts at reform were most needed, shaking the faith of international investors and ordinary Americans alike.

The most palpable concern was that gridlock had deprived policymakers of the monetary and fiscal tools they needed to shore up one of the world's bedrock economies, which some feared was already close to stalling.

"Because of the very public and intense squabbles in D.C., already-anemic economic growth will be weaker, the unemployment crisis will worsen, income and wealth inequality will deteriorate further and, ironically, the fiscal dynamics will be more challenging," said Mohamed El-Erian, co-chief investment officer of the international bond fund giant Pacific Investment Management Co., or PIMCO.

China, Washington's largest foreign creditor, has been particularly blunt about other countries' exposure to Washington's partisan warfare. "The ugliest part of the saga is that the well-being of many other countries is also in the impact zone when the donkey and the elephant fight," China's state-run news agency Xinhua wrote in a commentary, referring to the symbols of the Democratic and Republican parties.

Reuters posed several key questions to dozens of investors, policymakers, strategists and economists to gauge the implications of what the debt ceiling fight means for America and the world. While their judgment was almost uniformly dismissive to dire, their collective judgment was not entirely bleak: Republicans and Democrats were at least united on the fact that America must get its fiscal house in order.

WHAT DOES IT SAY ABOUT AMERICA'S ABILITY TO REMAIN THE WORLD'S SUPERPOWER?

Virtually everyone agreed that America's fiscal path is unsustainable: With a national debt of more than $14.3 trillion, the U.S. borrows forty cents of every dollar it spends.

Yet there is intense, fundamental disagreement on how to solve the problem, with Tea Party Republicans as passionately opposed to increasing taxes as progressive Democrats are to making deep cuts in the Social Security pension system and other so-called entitlement programs.

In the marginalization of the political center and dismal prospect for expedient reform, experts saw a threat to America's geopolitical strength.

"It's hard to maintain your influence globally when you can't manage your own country," said Barry Bosworth, a veteran fiscal and monetary policy expert at the Brookings Institution.

The former chair of President Barack Obama's Council of Economic Advisers tacitly agreed. "There is no way we can have persistent deficits of the size the Congressional Budget Office is predicting over the next 25 years and hope to remain the world's preeminent economic superpower," said Christina Romer, who left the CEA in September 2010. "If we don't deal with these deficits there is no way we won't eventually default and become a much weaker country."

Many Republicans and some Democrats fear that defense cuts could have the same effect. At least $350 billion of the initial $917 billion in spending cuts over 10 years are to come from defense and other security programs, which now account for more than half of discretionary spending.

The Pentagon budget for fiscal year 2010 was $680 billion, a reminder of the vast size and reach of America's global military power.

Many, including Pentagon experts, worried that another $500 billion of cuts over the next decade, which could be triggered by a failure of the second phase of the compromise plan, would gravely undercut the United States' international influence and its ability to execute a muscular foreign policy.

Pressure on the dollar as the world's reserve currency would also have geopolitical repercussions.

In the short-term, the United States' and the dollar's world standing is safe, because no other country is able or willing to take its place. Europe's own deep crisis with indebted nations such as Greece, Ireland and Portugal means that the euro is not quite the stable bet it once seemed to be, and China has no clear alternative to buying U.S. bonds to prevent its huge trade surplus from driving up the value of its tightly managed yuan.

But China's economy is rapidly shifting, and its need for reserves of Treasury debt will shrink, according to Stephen Roach, a senior lecturer at Yale University and non-executive chairman of Morgan Stanley.

Beijing's latest five-year economic plan focuses on building up domestic consumption, and China could even post a current account deficit by 2015, Roach said - meaning it would no longer need to buy as much debt. "They are moving away from the dollar whether we like it or not," he said.

If the dollar lost its status as the world's reserve currency it would do more than undercut America's geopolitical position: It would drive up interest rates and borrowing costs for the government, businesses and households.

PIMCO's El-Erian described the debt-limit battle as a "self-inflicted wound that weakens the economy and erodes its standing globally."

John Steele Gordon, a financial historian, downplayed the immediate effect of the debt-ceiling fight. "I don't think it will change the U.S.'s superpower status to any degree. We've had these knock down fights before."

Yet he too saw the government's budget deficit as make-or-break for America's place in the world: "What will affect superpower status is if the U.S. continues to spend more money than it takes in."

HOW MUCH DOES THE DEBT DEAL FIX THE U.S. FISCAL CRISIS?

There is no way to curb soaring U.S. debt without confronting three of the biggest drivers of American spending: Social Security, Medicaid and Medicare. Deep cuts in any of them represent deal-breakers to large and powerful political forces.

Left unreformed, these three programs - the federal pension system and the programs that support health care for the poor and the elderly - would devour every cent of America's tax revenues by 2047, according to the non-partisan Government Accountability Office.

Yet even with the threat of a catastrophic default as an incentive, and agreement by both parties that deficits must be brought under control, the debt-limit deal that finally emerged still failed to include robust reform of what are described as "entitlements".

The failure is symptomatic: Every important economic lever must work against a big political stick in the gears.

With more government stimulus "off the table," the slow-growing economy cannot generate enough jobs to pull down the unemployment rate. That in turn means Washington has to spend even more than expected on unemployment benefits, food stamps, Medicaid and other programs. Cuts in those programs would then become even more painful.

With tax hikes likewise "off the table," tax revenues will be restrained by weak consumer spending and idled labor.

And so on.

As a result, PIMCO's El-Erian expected the debt-ceiling compromise to do "very little, if at all" to fix America's underlying fiscal crisis. "Remember a sovereign debt burden is defined as total liabilities relative to a country's ability to service them. So it is not just about the debt stock, the maturity profiles and interest rates. It is also critically about the ability to grow. And this crisis has undermined growth, investment and employment."

Romer said "a holding pattern" is the most likely outcome of the debt debate saga. "It deals with the immediate issue of the debt ceiling but doesn't face up to our long-term deficit problem."

Morgan Stanley's Roach put it bluntly: "Make no mistake, we are not getting a major breakthrough in America's fiscal dilemma out of this deal. Talk about kicking the can down the road - this is probably the biggest can that's ever been kicked."

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