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Debt ceiling battles may hurt the U.S. dollar

While China is patiently building up credibility, America is spending it down.

- October 16, 2021

Congress and President Biden this week lifted the debt ceiling until December, temporarily averting a government default on the nation’s debt. Failure to lift the cap would have left the U.S. Treasury unable to pay for spending that Congress has already approved.

In the wake of this stopgap step, interest rates on short-term government bonds are again trending toward the Federal Reserve’s near-zero interest rate target, a sign of investors’ confidence in the U.S. dollar.

But kicking the debt down the road leaves the U.S. economy — and its most lucrative asset, the U.S. dollar — vulnerable to further political shocks. Here’s why.

Credible commitments to paying debts matter

Healthy relationships between creditors and debtors depend on debtors demonstrating a credible commitment to repay their debts. Long-standing institutional economics literature notes that creating and abiding by institutional rules can improve the credibility of national promises to repay debt by reducing opportunities for political mischief.

Initially established by Congress in 1917, the debt ceiling was an institutional rule intended to improve the U.S. Treasury’s capacity to manage U.S. debts by streamlining congressional approval. Once routinely approved by Congress, which has voted on debt ceiling measures more than 100 times since the 1950s, the debt ceiling has increasingly become a political tool for the opposition party to signal its discontent with deficit spending. In 2021, GOP lawmakers are objecting to debt incurred from Biden’s Build Back Better plan.

Ironically, by magnifying the stakes of political theater over the budget, the debt ceiling undermines the credible commitment of the U.S. government to pay its debt. Few creditors doubt the U.S. capacity to pay, but debt ceiling politics clouds market perceptions about America’s willingness to pay its debt.

As we saw during a previous debt showdown in 2011, S&P downgraded the U.S.’s AAA rating one notch to AA+, citing “weakened predictability of American policymaking and political institutions.” In the current partisan spat, another bond rater, Fitch, affirmed the negative credit outlook on the U.S. AAA rating, saying that “governance is a weakness” because of the “lack of bipartisanship and difficulty in formulating policy and passing laws in Congress.”

Debt politics threaten low interest rates

Brinkmanship over lifting the debt ceiling also puts at risk the low interest rates that have prevailed in the U.S. since the 1990s. A central reason for the persistence of these low rates has been the world’s long-standing demand for U.S. dollars. International investors searching for safe, long-term investment returns have bid up prices on U.S. Treasury assets, which correspondingly drives U.S. interest rates lower.

And those low rates are a key ingredient to U.S. economic growth. Low rates helped fuel the economy’s unprecedented expansion through the turn of the century and buttress it during two recent crises: the 2008-2009 global financial crisis and the 2020-2021 coronavirus pandemic.

Debt politics also affect U.S. competitiveness with China

Senate Democrats and Republicans may not agree on the debt ceiling. But they’ve proved their willingness to overcome partisan differences over U.S.-China policy. With the goal of countering China’s growing global economic influence, the Senate recently passed legislation aimed at strengthening U.S. technological and industrial capacity through quarter trillion-dollar investments in R&D and semiconductor manufacturing. A statement by President Biden noted, “we are in a competition to win the 21st century, and the starting gun has gone off.”

In this competitive context, the dollar gives the U.S. an advantage. It’s not only the symbol of U.S. economic might, but it’s also a sound, safe currency whose wide circulation is at the heart of global commercial activity. Even during the world’s recent crises, global investors rarely doubted the full faith and credit of the U.S. government. This allowed the U.S. government to finance its obligations cheaply over a long-term horizon, in contrast to other highly indebted countries.

China strives for such economic power with its plans for internationalizing its currency, the renminbi. To compete with the U.S. dollar over the long run, China is applying a patient capital approach, employing its flagship foreign economic program, the Belt and Road Initiative, as a conduit to promote renminbi-based trade and investment transactions — these transactions now account for 12 percent of China’s world trade (excluding Hong Kong).

Beginning in 2016, the IMF also adopted the renminbi in its Special Drawing Rights (SDR), or basket of five currencies that make up its international reserve assets. Some Chinese government think tanks even talk about an eventual era of “de-dollarization.”

Foreign investors have been circumspect, however, about using the renminbi as a low-risk, safe investment given ongoing concerns about the predictability of China’s political and legal frameworks. The Chinese government’s commercial promotion efforts have helped the renminbi become the globe’s fifth largest reserve currency. U.S. currency reserves, which account for more than half of the world’s total currency reserves, nonetheless dwarf China’s 2 percent share of global reserves.

Over the longer term, U.S. politicians may want to think about ways to ensure that the U.S. dollar remains competitive as a safe-haven investment by eliminating investor uncertainty about U.S. willingness to pay its bills. Otherwise, the U.S. risks giving global investors an incentive to diversify their currency holdings beyond the dollar. That in turn would risk higher interest rates at home, undermining U.S. economic growth.

Could the U.S. scrap the debt ceiling?

The periodic need to raise the debt ceiling makes creditors wonder every few months about the U.S. government’s resolve to pay its debts. Endowing the U.S. Treasury with automatic authority to issue debt to pay for congressionally approved spending would help mitigate some of this uncertainty. Otherwise, political battles over the debt ceiling could leave the U.S. economy devoid of the cheap financing for governments, firms, and households that undergirds economic growth.

One solution would be to eliminate the debt ceiling altogether, a move Treasury Secretary Janet L. Yellen supports. That would bring the U.S. in line with most other countries and eliminate the uncertainty that puts the U.S. dollar at risk.

Stephen B. Kaplan is an associate professor of political science and international affairs at George Washington University and a global fellow at the Wilson Center. He is the author of Globalizing Patient Capital (Cambridge University Press, 2021), a new book on China’s international financing.