The failure of President Barack Obama and House Speaker John A. Boehner (R-Ohio) to agree on getting the then-$14.3 trillion national debt under control, this authoritative Wall Street voice asserted, meant U.S. “governance and policymaking [were] becoming less stable, less effective, and less predictable than what we previously believed.”
Stocks immediately tanked, and investors fled to the safety of . . . Treasury bonds. The 10-year interest rate fell a fifth of a percentage point after S&P’s announcement.
Rates have stayed down ever since. U.S. 10-year borrowing costs are at a record-low 0.69 percent now, even as the federal debt, driven by massive new deficit spending for coronavirus-related economic rescues, has hit $26.5 trillion, more than 100 percent of economic output — and “governance and policymaking” have set records for dysfunction. Its bluff called, S&P never carried out its threat of more downgrades.
What, then, is the limit for U.S. debt? Clearly, the ceiling is far higher than had been assumed by those of us taught that federal borrowing inevitably “crowds out” private investment.
In a landmark 2019 paper, former International Monetary Fund chief economist Olivier Blanchard showed that low interest rates, relative to economic growth, are much more of a historical norm than previously thought, and therefore likely more sustainable even at high levels of debt.
Debate among economists pits those who support exploiting low interest rates to borrow a lot today, while planning lower long-run debt, against advocates of modern monetary theory, who argue that debt is no concern at all, except in the unlikely event inflation appears.
Overblown as they may have been in 2011, however, S&P’s worries — “governance and policymaking” — remain relevant. The amazing marketability of U.S. debt stems from institutional factors rooted, ultimately, in history, law and politics.
The first two are positives: the United States’ liquid and open capital markets; and its strong rule of law, which creates a financial haven in a world of confiscatory despots.
The third factor, however, is a negative one: There’s no alternative. The U.S. dollar is the world’s reserve currency, having achieved that status when the country emerged as a global superpower after World War II. With 80 percent of all global trade denominated in dollars, along with 62 percent of central bank reserves, people have little choice but to save in dollar-denominated assets such as Treasury bonds.
The resulting vast international holdings of U.S. Treasurys — $6.8 trillion, according to the IMF — help keep our interest rates low.
This is the “exorbitant privilege” about which a French finance minister grumbled more than half a century ago.
Individuals, companies and governments — even the French! — are more likely to accept the U.S. privilege insofar as our free markets and the rule of law really work.
The more we rely on the fact that savers simply have nowhere else to go, however — if we take their investments for granted, while neglecting long-standing racial and other inequities, indulging in partisan conflict and asking little in the way of taxes from our own wealthy citizens — the more likely they are to look around for alternatives.
President Trump disrespects domestic rule of law and attacks international institutions — free trade, the transatlantic alliance, international organizations — upon which dollar-dominance also partly rests.
The intended targets of Trump administration financial sanctions are Russia, Venezuela and Iran, but even allies chafe at the unilateral use of U.S. economic dominance for political objectives.
Princeton historian Harold James foresees the dollar giving way to digital alternatives, as the United States lurches into a “late Soviet” decline. Less hyperbolically, Stephen Roach, a senior fellow at Yale University’s Jackson Institute of Global Affairs, notes that a currency’s value reflects “two forces — domestic economic fundamentals and foreign perceptions of a nation’s strength or weakness. The balance is shifting, and a crash in the dollar could well be in the offing.”
The dollar has been king for 75 years; the best hedge against its downfall is to make sure U.S. institutions remain more trustworthy than the alternatives. If we want to keep the exorbitant privilege, in other words, we’re going to have to check it.