Will geopolitics bail out the United States?

After last night's stunningly useless set of speeches, I'd put the odds of the U.S. not raising the debt ceiling by August 2nd at 1 in 2. Like many other observers, I'm finding it increasingly difficult to envision a deal that would get through the Senate while attracting a majority of House Republicans [You meant a majority of the House of Representatives, right?--ed. No, I meant a majority of House Republicans. I'm pretty sure that Boehner and the rest of the House GOP leadership will refuse to pass any debt ceiling plan that relies too much on House Democrats.]

So, it's gonna be a fun few weeks for those of us who study the global political economy. Let's start by thinking the unthinkable -- what will happen if there is a default?

I've expressed my feelings on the matter already, and I'm hardly the only one. That said, I've also hedged my bets been flummoxed by the lack of market reaction to the DC stalemate. The lack of market reaction to date has emboldened House GOP members to stand fast. Could they be right?

Tom Oatley, who pooh-poohed my fears of the debtpocalypse last week, makes an interesting point about the composition of U.S. debt-holders:

By these figures, about 63% of US government debt is owned by central banks (foreign and domestic) and/sovereign wealth funds. Most of these entities are American friends and allies. Another 4% is owned by US state and local governments. That leaves 33%--about $4.8 trillion--in private hands. Of this, the financial institutions with the most restrictive regulations regarding asset ownership (depository institutions) own only 2% of the total ($290 billion). Mutual Funds, who may or may not have to dump downgraded debt, hold another 9% ($1.35 trillion).

What's the point? The discussion about the impact of US default revolves around the market response to default. Useful to recognize that most of the US government debt is held by public-sector agents who are much less sensitive to balance sheet pressures and regulatory constraints. These public sector agents are also substantially more sensitive to "moral suasion" and direct appeal than private financial institutions. The structure of ownership of US debt might dampen the negative impact of any default that does occur.

This is pretty interesting. Oatley focuses on "moral suasion," but there's also a national-interest motive for many U.S. debtholders. Most of the official holders of U.S. debt have a strong incentive for a) the value of their holdings not to plummet; and b) the United States economy to continue to snap up other their exports. If China, for example, is buying up U.S. debt to sustain its own growth, then neither a technical default nor a ratings downgrade should deter China or other export engines from continuing to buy U.S. debt even if there's a spot of trouble.

So it appears that complex interdependence will force America's rivals to continue to hold U.S. debt even after the debtpocalypse!! The United States in the clear, right?

Not so fast. Here are five "known unknowns" I can think of that might complicate Oatley's analysis:

1) What if the creditors form a cartel? In my 2009 paper, this was the one scenario that gave me the heebie-jeebies, because it's the one scenario under which creditors can wring geopolitical gains from debtor states. Any kind of default can act as a focal point moment in which U.S. creditors decide it's time to apply a haircut to American power and influence.

I don't think this is going to happen, because the national interests of American debtholders remain divergent. That said, if U.S. allies interpret default as a signal of U.S. unreliability in times of crisis, then all bets are off.

2) What about the economic nationalism of China? China is the largest foreign debtholder, which gives it a certain agenda-setting power in moments of crisis. There are a lot of compelling reasons why China would decide to try to minimize the economic disruptions . On the other hand, there's a lot of resentment on Chinese Internet boards already about the Chinese purchases of U.S. debt. During a period in which the CCP is already concerned about domestic instability, one could envision a scenario whereby they try to mollify nationalists at home by acting out against the United States.

3) What would be the effect of a mild market reaction on the House of Representatives? The less the markets react, the less that the House GOP will feel a need to do anything. There will come a point, therefore, when official debtholders might need to signal to the House that, in IPE lingo, "s**t needs to get done." That signal would in and of itself roil markets, not to mention the effects the current uncertainty is already having on the real economy.

4) What is the fiscal shock from a default? There are two causal mechanisms through which a default could affect the global economy. The first is through panic and uncertainty roiling financial markets. The second, however, is from a dramatic fiscal contraction due to limited government spending. Given the lackluster state of the current recovery, it wouldn't take much to tip the United States back into recession.

5) What if there's another AAA bubble? FT Alphaville's Tracy Alloway provided another interesting chart earlier this month on the distribution of AAA securities:

A very scary chart

As Alloway warns:

[W]atch what starts happening from 2008 and 2009.

The AAA bubble re-inflates and suddenly sovereign debt becomes the major force driving the world’s triple-A supply. The turmoil of 2008 shunted some investors from ABS into safer sovereign debt, it’s true. But you also had a plethora of incoming bank regulation to purposefully herd investors towards holding more government bonds, plus a glut of central bank liquidity facilities accepting government IOUs as collateral. Where ABS dissipated, sovereign debt stood in to fill the gap. And more.

It’s one reason why the sovereign crisis is well and truly painful.

It’s a global repricing of risk, again, but one that has the potential for a much largerpop, so to speak.

We know that a downgrade of U.S. Treasuries would likely lead to a downgrade of state and municipal bond ratings as well. We also know that the ripple effects from the collapse of asset-backed securities were much larger than anticipated before the 2008 crisis. This is why the possible knock-on effects of downgrade so many AAA asserts makes me itchy. Even if banks and other financial institutions have minimal exposure to U.S. Treasuries, I don't think it's possible for them to have minimal exposure to all U.S.-based AAA sovereign debt.

These are just the five known unknowns that I could think of in the past hour -- there are probably many, many more. Readers are strongly encouraged to add them in the comments.

Daniel W. Drezner

The Achilles heel of the foreign policy smart set

Here's an open secret -- most American foreign policy observers loathe domestic politics.  To those who seek to define and distill the national interest, the notion that factions or parties can get in the way of the common good is very, very frustrating.  This is why, whenever gridlock breaks out in Washington, there is a spasm of caterwauling from prominent foreign policy thinkers that Something.  Must.  Be  Done. 

This leads to some silly memes, like claims that a third party will break the logjam.  It won't -- a glance at Duverger's Law and you know that the first-past-the-post electoral system in this country means that a two-party system is the only stable long-term equilibrium.  A third party in the United States could only achieve electoral viability in one of two ways:  either supplanting one of the existing parties, or focusing on success in a particular region.  Since neither of these outcomes has occurred since the Civil War, I'm not holding my breath. 

Gridlock frustration also leads to proposals of Grand Diagnoses and Remedies for Fixing the System.  Fareed Zakaria goes down this road, offering a diagnosis of why partisanship has been rising in the United States and then links to Mickey Edwards' essay in The Atlantic of how to fix things.  Zakaria, riffing off of Edwards, lists four reasons why partisanship is so high: 

1)  Redistricting has created safe seats so that for most House members, their only concern is a challenge from the right for Republicans and the left for Democrats....

2) Party primaries have been taken over by small groups of activists who push even popular senators to extreme positions.

3) Changes in Congressional rules have also made it far more difficult to enact large, compromise legislation.

4) Political polarization has also been fueled by a new media, which is also narrowcast.

These sound compelling, except that A) none of them really explain increased polarization in the Senate; and B) only the fourth trend is in any way recent (the rest of these phenomenas can be traced back to the 1970's).   

The real problem with Congress is that any proposed institutional reform to correct the problems would require either a dilution of legislative power or a dilution of the minority's power to obstruct.  Neither minority nor majority parties in Congress will be interested in moves like that unless and until we're in a crisis that made 2008 look like a ripple in the pond. 

If you are looking to this humble blogger for ways out of this current problem... um... look elsewhere.  My training is in international relations, and I've found that people with that kind of training tend to prefer policy reforms that provide political leeway and insulation to the executive branch.  These measures are appealing because they tend to minimize the number of stupid interactions with galactically stupid members of Congress.  Over the long-term, however, even a stupid Congress still serves as a valuable check on executive branch authority. 

I'm as frustrated as the next foreign policy observer when it comes to the current policy paralysis.  I know my own kind, however, and we suffer from the flawed belief that there was a halcyon era of bipartisanship in the foreign policy days of yore.  Be very, very wary when a foreign policy pundit gives advice about how to reform the American system of government.  Most of the time they are relying on decades-old Introduction to American Government arguments that are either obsolecent or incentive incompatible. 

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