This post is excerpted from The Reckoning: Debt, Democracy, and the Future of American Power, published by Palgrave Macmillan on April 10, 2012.
Americans must learn not to take their unmatched economic advantages for granted, lest they disappear. These advantages come in several forms, starting with the American currency. Because most of the world's trade is denominated in US dollars, the price Americans pay for most commodities (oil, for instance, or food) is just a bit lower than elsewhere, even if they may be subject to a little more volatility as part of the deal. Similarly, because the US Federal Reserve controls the number of dollars in circulation, America can sustain policies -- like the near-zero federal funds rate that has prevailed since the ﬁnancial crash -- that would have global bond markets baying for the blood of any other nation. These low rates effectively lower the ultimate return-on-investment foreign creditors will receive for purchasing American debt through the sale of US Treasury bonds and other government securities. With US national debt heading into record territory versus annual GDP growth, the ability to keep interest rates artiﬁcially low is no small advantage. But these perks of global dominance will erode along with America's hegemony, and erratic policy measures in Washington will speed the arrival of that day. Already global markets are chirping, and China, Russia, and other economic rivals have demanded that the dollar be supplanted as the global reserve currency by something else. This will not happen quickly unless American politicians, by strangling growth with budget cuts in the midst of a downturn, stupidly force the issue.
There is precedent for such stupidity, even outside David Cameron's Britain. In 1937, the US economy had ﬁnally, after nearly a decade, matched its size in 1929, the year the stock market bubble popped and the world cascaded into the Great Depression. Then, the deleveraging process was even longer and harder in every measure than it is today. By 1937, modest growth had returned, and while unemployment remained stubbornly high at just under 10 percent, that was down from a peak in 1932-33 of 25 percent.
At this point, both the Fed and the Roosevelt administration -- giving in to orthodoxies that still haunt US economic thought -- made terrible, independent errors. FDR acceded to Treasury advisors who declared the recovery self-sustaining and pushed for spending cuts. FDR, by now in complete control of the congressional agenda after a landslide reelection in 1936, duly cut government spending by 10 percent in an effort to balance the federal budget. The Works Progress Administration (WPA), which had employed three million in 1936, was sharply curtailed, as were other "emergency programs." The Federal Reserve, meanwhile, had been rattled by recent gyrations in commodity prices, particularly in corn and wheat -- crops devastated by the Midwestern Dust Bowl. Acting to tame what it saw as the threat of hyperinﬂation, the Fed raised interest rates sharply. Various economic schools assign different weight to these two decisions, but the overall math is devastatingly clear. By 1938, joblessness had shot back toward 15 percent, industrial production fell by 37 percent, and the worst double dip in US history had begun.
Could the mistake of 1937 be recurring as we speak? Ben Bernanke, who as chairman of the Federal Reserve bank has a relatively free hand in interest rate policy, has spent his career promising it would never happen. "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again," Bernanke said back in 2002 at a conference honoring the ninetieth birthday of economist Milton Friedman, godfather of the monetarist school and a man whose scholarly work contends that it was the Fed, not FDR, whose error threw the country back into the Depression in 1937.
Yet Bernanke, who has also made the unprecedented promise to the market that the Fed will keep real interest rates below 1 percent until at least 2013, could still repeat the mistake -- or rather have it imposed upon him by the more orthodox members of the Fed's policy-making board, which consists of the chairmen of regional reserve banks. For instance, St. Louis Fed president James Bullard has been agitating for changes in the way inﬂation is computed to take greater account of spikes in energy and food prices. He also agrees with Dallas Fed president Richard Fisher, an inﬂation hawk, who has opposed Bernanke's policy of "printing money" to stimulate the economy -- a technique known as quantitative easing or QE. Should these voices come to dominate the Fed's board of governors, Bernanke could be forced to swallow his promise to Friedman.
The mistake far more likely to be repeated, however, is FDR's. In this scenario, Congress -- led by the GOP's fundamentalist Tea Party faction -- forces a drastic cut in government spending that turns an anemic recovery into another steep downturn. Automatic spending cuts and other gimmicks may see the United States through the 2012 election, though Obama will once again need to win approval to raise the debt ceiling. By then, we can hope, the GOP leadership will have regained some control over their caucus. But in the heat of a presidential primary season, they may also smell blood, and the worst political instincts will prevail. If so, the prospect of a default greatly increases, ironically threatening to accomplish exactly the opposite of what Republicans aim for: expanding the federal government. Simon Johnson, a former chief economist of the IMF and now a professor at MIT's Sloan School of Business, explains that a US debt default would cause the private sector to collapse and unemployment to surpass 20 percent. So while the government would shrink, it would remain the employer of last resort and thus get larger, not smaller. "The Republicans are right about one thing: a default would cause government spending to contract in real terms," Johnson says. "But which would fall more, government spending or the size of the private sector? The answer is almost certainly the private sector, given its dependence on credit to purchase inputs. Indeed, take the contraction that followed the near-collapse of the ﬁnancial system in 2008 and multiply it by ten. The government, on the other hand, has access to the Fed, and could therefore get its hands on cash to pay wages."
Avoiding a Second "Great Recession"
All of this has the average American's head spinning. Whom should they believe? Distinguished economists? Politicians? Radio talk show hosts? Amid all the blather about defaults and inﬂation, monetary policy and sovereign credit, one uncomplicated fact looms: a national debt that will soon be larger than the annual output of the world's largest economy. It's as ﬁrmly lodged in American minds as the Soviet Union after Sputnik. It's not surprising that well-meaning citizens are falling prey to ideologues. It happened in the 1950s, and it is happening again today.
But this is not a Chicken Little moment; the sky will not fall if economic policy is driven by reason, rather than panic. The "debt scare," like the Red Scare of the Cold War, is all too easily leveraged precisely because it is based in reality. Politicians who advocate swift, searing solutions are focused solely on short-term impact -- that is, electoral politics. If ever there were a moment in American history to focus on the longer term, this is it. The solutions to America's debt problems will take much longer than a two-year term in the US House of Representatives.
Since World War II, the United States has enjoyed "preferred customer" perks around the planet, its credit hovering well above the 720 rating that the most valued American consumers generally enjoy. But a credit rating is a delicate thing -- even a small error or oversight can have negative consequences. Most Americans know how frustrating it can be to deal with one of the seemingly faceless, supposedly omniscient agencies that rate consumer credit. If Equifax, Experian, or TransUnion suddenly decides you no longer deserve a high credit rating, good interest rates on your car or home loan suddenly are out of reach. For an individual, the difference over the life of a loan can be tens of thousands of dollars, or a realization that the purchase is simply out of reach.
Governments, too, as America learned in the summer of 2011, are subjected to credit ratings. As in consumer life, three supposedly all-knowing ﬁrms rate the likelihood that, say, Nigeria will repay a ten-year loan represented by the sale of a $500 million government bond. S&P, one of those ﬁrms, gave a B+ rating to one such bond offering in January 2011, which may sound good to those who happily accepted that grade to get through high school chemistry but is actually a long way from the AAA rating the US government bond offerings enjoyed until recently. Nigeria had to promise to pay almost 10 percent interest on that bond in order to sell it -- a very steep cost and a burden on the national budget for the life of that loan. But the United States borrows frequently and freely, and even with its diminished AA+ rating, other factors -- like the reserve currency status of the dollar -- allow it to sell a similar US Treasury bond and pay just around 3 percent interest.
For any nation-state, or sovereign, as ﬁnancial experts call them, the prospect of national bankruptcy means losing control over important elements of national policy making. If creditors stopped purchasing America's debt, it would force cuts that even the Tea Party would blanch at. Interest rates on everything from mortgages to student loans would skyrocket, and many middle-class families and small businesses would be shut out of the credit market. Before long, roads and railways would deteriorate, federal prisons and hospitals would teeter, public schools and universities would slide in quality, border controls and customs would lose integrity, and mail would be delivered weekly rather than daily. Local governments, already stressed, would lay off police ofﬁcers, ﬁreﬁghters, and other civil servants in droves. Military and civil service pay and pensions would be radically curtailed, and the size of the armed forces would be pared back. Small business loans would dry up, and a black market would emerge for many of the services formerly funded by taxes -- all of it acting as a drag on the kind of economic growth vital to breaking the downward spiral. Here, in detail, is the "disruptive and destabilizing" results of a failure to act rationally described by GAO's audit.
Then there is the intangible inﬂuence of politics. Anger and economic dis-location raise crime rates and fray civility. The natural turning inward in such circumstances only adds to the spiral of decline, and once that spiral begins the bottom is hard to deﬁne. None of this may loom ahead for the United States, yet something disconcertingly similar appears to be stalking the nations of the EU's euro zone -- those countries that use the euro as a common currency. Anger runs high in northern Europe's stronger economies -- Germany, the Netherlands, and Finland, in particular -- about the funding they have extended to Greece, Ireland, Portugal, Spain and Italy to help those high-debt countries stave off default. This resentment has vaulted elements of the far right to power in these countries around the continent, from Umberto Bossi of Italy's surging Northern League, which would like to separate the wealthy north from the rest of the country, to the Dutch Freedom Party leader and anti-Muslim agitator, Geert Wilders, now leading a major parliamentary force in the once ultratolerant Netherlands. It has also fueled a violent backlash against immigration. Indeed, a very similar combination of economic collapse, diminishing global power, debt payments for foreigners, and national humiliation helped fuel the rise of Adolf Hitler in the 1930s, as well as the earlier crises that toppled Tsarist Russia, China's Nationalists, and Spain's monarchy before its bloody civil war.
America has nothing yet to fear from peasants with pitchforks, but well-organized digital insurgents selectively quoting from those revolutionary eighteenth-century texts are their equivalents in the current crisis. The modern Tea Party movement offers no thoughtful solutions; their modus operandi is anger mixed with raw austerity, a perfect prescription for the economic death spiral just described. Yet the movement may come and go without leaving too much of a mark on the country's politics -- it is too early to tell. Certainly, the difﬁcult times ahead will make it easy to sow discontent. As life's luxuries move out of reach of the US middle class, the backlash against those who continue to prosper will be profound. Anti-immigrant sentiment will grow, too, and populism will undermine the remaining free trade consensus in Congress, insisting that America's ailing industries be protected with tariffs. (For a sense of why this would be disastrous, examine what happened during the Great Depression when a trade war touched off by the notorious Smoot-Hawley Tariff Act added years and untold depth to the crisis.) Structural unemployment that remains at around 9 percent will have social ramiﬁcations, too. Young people unable to ﬁnd work tend, fairly quickly, to add to crime statistics. This is a dangerous place to be: if the difﬁcult decisions about repairing America's ﬁscal ailments are put off and its global credit worthiness lowered, its decline will have become irreversible. In such a political atmosphere, reason loses its hold, leaving anger and passion alone to drive the debate on national destiny.