Nadine Hani: Could US debt default be conceivable?

Democrats and Republicans in the US Congress are engaged in a dangerous clash and time is running out before August 2, the date after which the United States will not be able to pay its bills. And even if they manage to reach an agreement, as expected, the damage has already been done, as rating agencies warned of downgrading the US’s AAA Credit Rating, which makes it lose its “risk-free” status if the federal debt problem is not settled. Why is this political fight taking place then? And what would happen if the US debt ceiling was not raised by the August 2 deadline or if the US credit rating was downgraded?

The US federal debt today stands at $14.5 trillion, equal to 98 percent of the US GDP, and it is expected to reach $20 trillion in 2016. If it were a private company which had this large amount of debt it would have been bankrupt. But the US government runs the world’s largest economy, enjoys the best credit rating and controls the world’s foreign reserve currency, the dollar. The public debt has reached its limit and the US treasury needs congressional approval to continue borrowing money and paying its loans. After August 2, the United States will enter a phase of technical default if the debt ceiling is not raised.

Both parties apparently have not taken the debt crisis seriously enough as they seek to score political points ahead of the 2012 presidential elections in their dispute over the issue. But the more dangerous reality is the fact that both parties lack a comprehensive strategy to confront the problem of public debt. The Republicans reject tax increase and demand cutting government spending, including on health care and social security, something the Democrats vehemently oppose.

Republicans have proposed to raise the debt ceiling in two phases, with a smaller increase of about $1 trillion immediately, which would carry the government until the end of this year, accompanied by a similar amount of spending cuts. The second increase would then be put to a vote again early next year.

The Democrats have agreed not to raise taxes, despite that this is what President Barack Obama is calling for, but they reject any cuts on entitlement programs such as Medicare and Medicaid. Their proposed spending cuts are unachievable and criticized as “gimmicks” by the Republicans. But Democrats want to increase the debt limit enough to last the treasury until the 2012 presidential election.

Both approaches are flawed. The federal budget problems cannot be redressed without raising taxes in parallel with a reduction in spending, including on healthcare, otherwise there will not be significant spending cuts. And the idea of voting again on raising the debt limit next year prior to the presidential election is unrealistic because at that time narrow political agendas will overshadow the actual economic problem and will hinder economic reforms even further.

The scenario of technical default is unlikely and if it happens it will be felt worldwide because many countries have invested in US government bonds and they will sustain heavy losses in the case of a US default. Besides, such a scenario could seriously disrupt credit markets. US Treasury securities are used as a benchmark for pricing global securities. According to JP Morgan, half of the US government bonds issued is used as collateral in the futures, derivatives, and repurchase agreements’ markets, which are crucial for the short-term funding of financial institutions.

And even if the debt ceiling is raised, repercussions of shortsighted policies could cost the United States its “risk-free status.” This will raise the cost of borrowing for the government by about $100 billion annually, therefore canceling out the effects of the spending cuts that are being argued over right now. The economic damage will then be felt by citizens and companies alike as the cost of borrowing will increase for all. As for international funds that allocate a part of their portfolio to invest in the risk free US Treasury bills, they will have to alter their strategies because they will not find another alternative to the US, since no country has the reserve currency that it has, and is in a position to take its place.

(This article appeared originally in Arabic in An Nahar newspaper on Thursday, July 28. Nadine Hadi, Senior Business News Presenter at Al Arabiya, can be reached at [e-mail], and Twitter at: @Nadine_bn. The translator was Mustapha Ajbaili, Managing Editor of Al Arabiya English, who can be reached at: [e-mail])