The risk of a near-term U.S. default appears to have dissipated following Thursday’s congressional agreement to reopen the government and extend its borrowing authority into February. Short-term bond yields, which move inversely to prices, are once again trading close to the Federal Reserve’s near-zero interest rate target. The White House hailed the pact, which it said would “remove the threat of economic brinkmanship.”
But simply extending the debt ceiling deadline a few months leaves the U.S. economy and its most lucrative asset – the dollar’s status as the world’s reserve currency – vulnerable to further political shocks. The world’s longstanding demand for dollars has provided a key ingredient to U.S. economic growth: low long-term interest rates. These rates helped fuel the U.S. economy’s unprecedented expansion through the turn of the century and buttress it during the recent global financial crisis. We can think of interest rates as part of the “floor” underpinning our economy. The problem is that brinksmanship involving the debt ceiling threatens default and thus warps this valuable interest-rate floor. The necessary solution is to eliminate the debt ceiling.
A credible commitment to debt repayment is the cornerstone of a healthy relationship between creditors and debtors. Even during the 2008-2009 recession and financial crisis, global investors rarely doubted the full faith and credit of the U.S. government. This allowed the U.S. to finance its obligations cheaply over a long-term horizon, separating it from other highly indebted countries. These other countries have often struggled to stay afloat, given the relatively short-term horizon provided by international investors. Concerned that these governments might default, investors have often issued debt with maturities of less than one year. As I show in my book, many developing countries have built institutions, such as currency boards, fiscal rules, inflation targeting, and independent central banks, in part to convince creditors that default was unlikely. This has worked, providing economic stability but often at the cost of lower growth and employment and sometimes even social instability.
Despite these economic reforms, a short-term refinancing horizon leaves countries vulnerable to rapid changes in investor sentiment. As governments from East Asia to Latin America know all to well, sudden capital withdrawals can produce dramatically higher interest rates and leave economies in shambles. Argentina, Brazil, Mexico, South Korea, Thailand, and more recently much of Southern Europe, have suffered such a fate, turning from economic tigers into economic turkeys seemingly overnight.
Repeated budgetary stalemates have started to make the U.S. look like a turkey too. Few creditors doubt the U.S.’s capacity to pay its debt, but the political theater surrounding the debt ceiling has clouded market perceptions about the U.S.’s willingness to pay its debt. Most recently, Fitch Ratings expressed concern about “the prolonged negotiations over raising the debt ceiling,” placing the U.S. on watch for a potential credit downgrade.
Similar concerns are evident abroad. The U.S.’s low interest rates arise in part because we borrow so much from countries with a long-term stake in the global economic system. China, Brazil, Japan, Singapore, and others invest in dollars not because dollars are profitable but because they represent safe, liquid assets. This helps explain why foreign governments hold almost two-fifths of the $11.6 trillion U.S. debt. With these governments among its major creditors, the U.S. has been less subject to the whims of short-term private capital. In return, foreign governments simply ask that these assets hold their value over time so they are available for financial insurance or reserve management purposes.
Over the last two years, however, these governments have become increasingly skeptical about the U.S.’s fiscal governance. During the first debt ceiling showdown in 2011, China expressed its “hope that the U.S. government adopts responsible and measures to guarantee the interests of investors.” More recently, however, China’s sentiments have become far less mild. China’s state newspaper, Xinhua, said that it was time to “start considering building a de-Americanized world” that would include the “introduction of a new international reserve currency.” And notwithstanding the budget deal, China’s largest credit rating agency, Dagong Global, downgraded U.S. debt.
To mitigate this growing global scrutiny and rising interest rate premium, the U.S. should scrap its debt ceiling. It serves such little economic purpose that most countries do not have it, and in the U.S. it often has been used as a political tool, allowing the opposition party to signal its discontent with deficit spending. In 2006, for instance, then Sen. Barack Obama opposed raising the debt limit saying, “America has a debt problem and a failure of leadership.”
By magnifying the stakes of political theater over the budget, the debt ceiling undermines the U.S.’s credible commitment to pay its debt. It imposes a short-term financing calendar, with creditors wondering every few months about the U.S.’s fiscal resolve. By definition, AAA borrowers should not be subject to such market uncertainty about their financial commitments. Endowing the U.S. Treasury with automatic authority to fund congressionally approved spending will help mitigate some of this uncertainty. Otherwise, political battles over the debt ceiling may leave the U.S. economy devoid of its most important insurance: its cheap financing for governments, firms, and households.