Columns

Don't Play with America's Full Faith and Credit


Last fall's elections tapped a well of public mistrust of big government that had been building for decades. Facing an almost-unprecedented wave of anti-incumbent fervor, long-serving senators and representatives lost reelection bids. Many powerful incumbents even failed to survive their party primaries.

Republicans took control of the House of Representatives and poached a significant number of Senate seats and numerous governorships. The party also seized control of more state legislatures than it had run since the Great Depression.

The agenda for most 2010 candidates was much the same: Cut government spending and boost the economy. While "Tea Party" favorites received much of the attention, moderate Democrats from Rep. Gabby Giffords (D-Ariz.) to Senator Joe Manchin (D-W. Va.) also articulated a "cut government spending" message. Slashing the federal budget and U.S. debt were the objectives; government shutdowns and a refusal to raise the debt ceiling were the levers to achieve them.

In the lame-duck Congressional session following the elections, Democrats in the White House and Congress, sensing the public's mood, quickly acquiesced to Republican demands that the "Bush tax cuts" be extended. Neither side declared victory. Rather, critics on the left and right felt betrayed by their leadership. Leadership on both sides promised their base that they would achieve more in the coming fiscal battles.

Why a U.S. Debt Ceiling?

Now that Congress has struck a deal to cut $38 billion from the 2011 federal budget, attention has quickly turned to the need to raise the federal debt ceiling. While the debt ceiling is much debated, the issue is not well understood. Many Americans believe Uncle Sam can simply print dollars. That is not the case. To the extent that federal expenses exceed revenues, the U.S. government must borrow the difference. The total amount that the government can borrow is set by law. The limit on government borrowing, the so-called "debt ceiling," is currently set at $14.3 trillion.

That limit could be reached within weeks.

Congressional leaders may be even more reluctant to accept compromises in the coming battle to raise the debt ceiling. President Barrack Obama has urged them to raise the debt ceiling without conditions. The President's critics can point to then-Sen. Obama's 2006 vote against raising the debt ceiling as proof that this issue has always been somewhat politicized. But while an unwillingness to seek a bipartisan approach to the debt ceiling might be good party politics, it is clearly bad policy.

To understand how the debate over raising the debt ceiling could affect the U.S. economy, one must understand the underpinning of American economic power. Since World War II, the U.S. has enjoyed unprecedented dominance of the global economy. Today—and for several decades to come—the U.S. is the world's largest economy. Sometime in the first half of this century, China's gross domestic product is likely to exceed U.S. GDP. Even when that happens, American per capita income will well exceed China's per capita income.

The other pillar of American economic strength is the U.S. dollar, long the world's reserve currency. As owner of the global reserve currency—essentially the one that all central banks must hold—the U.S. is able to borrow in dollars rather than in another country's currency. For a nation with more than $14 trillion in national debt, the capacity to borrow in our own currency is an enormous benefit and privilege.

Dollar Shock With Dire Aftereffects

Should the federal government be unable to borrow more dollars, government spending will essentially slow to a trickle. Cash raised through taxes would be used to provide essential services. In all likelihood, the U.S. Government would be unable to pay its debt. While such a failure to repay federal debt would be applauded in certain quarters, it would send shock waves through the global financial markets. The markets would recover, but the dollar's unique global status, the U.S.'s AAA credit rating, and the U.S. economy would be harmed.

Loss of confidence in the dollar would have profound, negative consequences for the U.S. economy. JPMorgan Chase (JPM) Chief Executive Officer Jamie Dimon, echoing the sentiment of the global financial community, has said that were the U.S. to default on its debt, the consequences would be "catastrophic and unpredictable." The dollar would quickly lose its reserve currency status and consequentially, all the benefits that brings to the U.S. economy. It would cost the U.S. government more to borrow, putting more pressure on Washington to cut entitlements and raise taxes. In addition, Americans would pay more for imports, from oil to clothes to consumer electronics.

Does the federal government need to reduce the deficit? Of course. Growth in the U.S. deficit and debt is simply not sustainable. Congress and the White House need to make tough decisions, even if that means they might be labeled as "sellouts" and "moderates" by party extremists.

Those tough decisions should be made in the context of a budget debate, rather than brinksmanship over raising the debt ceiling. To do otherwise might bring momentary pleasure, but the long-term consequences could be dire.

Frank_aquila
Aquila is a partner in the Mergers & Acquisitions Group of Sullivan & Cromwell LLP.

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