There are many reasons for dysfunction in the American political system. There are also many reasons why “Pax Americana” – the period of U.S. dominance since World War Two - is under stress. But the end of the era of free money is a new toxic ingredient in the witches' cauldron that links domestic political conflict and Washington’s struggle to rise to a host of global challenges.
The combination of high bond yields with a large fiscal deficit and rising sovereign debt is making it harder for politicians to govern the country. Witness President Joe Biden’s battle to get Congress to approve $106 billion in military aid for Israel and Ukraine, as well as cash to push back against China in the Indo-Pacific.
The federal government doesn’t just need money to boost its defences and those of some allies. It needs extra funds for pensions, health care and low-carbon technologies, as well as to compete with China for influence in developing countries. Meanwhile, higher interest rates will ratchet up the cost of servicing its borrowings.
Rising bond yields are having similar effects on other rich countries. Many will also struggle to fund both domestic and international priorities. If anything, they may have a tougher job to make their fiscal maths add up than the United States because their growth prospects are not as rosy.
American allies in Europe and Asia are hiking their own defence spending in response to the rising threats from Russia and China. But the money has to come from somewhere. Post-Brexit Britain, for example, has cut its foreign aid budget, undermining its soft power.
NO MAGIC MONEY TREE
While borrowing costs may just have reverted to their long-run average after a period when central banks kept them artificially low, a generation of politicians grew up believing money grows on trees. They threw cash at a raft of problems, including the Covid-19 pandemic and climate change.
U.S. public sector gross debt almost doubled from 65% of gross domestic product in 2007 to 121% last year, and will rise further to 137% by 2028, according to the International Monetary Fund. This is largely because the projected fiscal deficit of 8.2% of GDP this year will still be 7.0% in five years’ time.
The dollar’s status as the world’s reserve currency means the United States has more freedom to run up debt than its allies. It’s unlikely to suffer the fate of Britain, which experienced a mini-bond crisis last year when short-lived Prime Minister Liz Truss tried to cut taxes while increasing spending. Meanwhile, the euro crisis showed that members of Europe’s single currency cannot run up debts with abandon. Recent jitters n the Italian bond market indicate these limits haven’t gone away.
But Washington, too, will ultimately have to bring its borrowing under control, says Paul Tucker, author of “Global Discord” and a former deputy governor of the Bank of England.
Ideally, this would happen as a result of a reasoned debate about relative spending priorities and options for raising tax, for example by carbon pricing. But a more chaotic process could end up sacrificing international programmes.
Until recently, this would have been unthinkable given the broad political consensus on maintaining national security. But some Republicans in the House of Representatives are now less keen on supporting Ukraine.
The breakdown in the consensus hasn’t just led to problems over Biden’s jumbo request for military aid. It has also caused repeated standoffs over raising the government’s debt ceiling, prompting Fitch to downgrade the U.S. government’s credit rating from AAA to AA+ in August.
THE LAND OF THE BLIND
The United States’ arch-rival China has even more serious debt problems. Its population is ageing more rapidly and it is more exposed to climate change.
When private borrowing is included, China’s debt is three times its national income, according to data from the Bank for International Settlements. By contrast, total U.S. debt is about two-and-a-half times GDP. Moreover, much of China’s borrowing has been used to fund unproductive investments, with the result that local governments, property companies and shadow banks are saddled with bad debts.
All this means the People’s Republic will also need to pick its spending priorities. It has already cut back its Belt and Road Initiative, an infrastructure plan to woo developing countries.
China does not face the same interest-rate headaches. It does not depend on overseas capital to finance its debt. And yields on the 10-year government bond are only 2.67%, almost two percentage points lower than their U.S. equivalent. But this reflects the need to support China’s sluggish economy.
What’s more, the near-record yield gap with the United States is bringing its own headaches by putting downward pressure on the yuan.
China’s domestic savings are mostly trapped behind capital controls. But the tighter these are, the less appealing the yuan is to foreigners – undermining China’s goal of boosting its currency as an alternative to the dollar.
These are consolations for the United States as it grapples with the geopolitical consequences of high interest rates. Nevertheless, Washington faces some difficult choices. There is no guarantee it will make wise ones.
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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)
