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Debt risk appalling, but solution is simple

By Steven Kyle, Special to CNN
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STORY HIGHLIGHTS
  • Steven Kyle: U.S. would be shooting itself in the foot by defaulting
  • Kyle says move could squander America's privileged status in world economy
  • Kyle: Interest rates could rise, chaos could touch off a depression
  • He says solution is to wind down the wars and let Bush tax cuts expire

Editor's note: Steven Kyle is a professor of applied economics in the Dyson School of Applied Economics and Management at Cornell University. He has worked on macroeconomic policy both in the United States and abroad and formerly was a staff economist at the World Bank.

(CNN) -- As one who teaches Economics 101 and, as a professor and international consultant who makes a career out of giving macroeconomic advice to other countries, I find the current impasse in the United States both appalling in its potential risks and frustrating in the simplicity of the solutions that are hardly even talked about.

The implications of a U.S. government default are far bigger and far more uncertain than most accounts would have you believe. It is certainly true that the immediate effect would be higher interest rates on U.S. government bonds -- with depressing effects on any economic activity that is interest sensitive, from real estate to business investment to student and consumer loans.

In other words, we would be kicking an economy that is already in a fragile state. (The government reported Friday that the economy grew in the second quarter at only 1.3%.)

Worse than that, and much more uncertain, is the effect of setting adrift what has been the anchor of the world economy for many decades. The U.S. dollar and U.S. Treasury obligations have long been the rock solid basis for measuring the value and risk associated with every other currency and financial asset in the world.

Who will lose if there is a default? The first losers will be everyone with a stock or bond portfolio.
--Steven Kyle
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We would be putting an end to that, and the consequences are largely unknown since no country on Earth ever has or ever would voluntarily depose itself from that favored position. Being the world's reserve currency gives us an immense free ride when it comes to economic policy.

We, and we alone, get to spend billions of dollars and watch as other countries in the world simply absorb them as international reserves. Their willingness to hold large amounts in dollar assets such as Treasury bonds means our interest rates are permanently lower than they would be otherwise, something that we have come to take for granted but won't be able to keep on doing if we default.

While it would be tempting to view the euro as a viable alternative, the current disarray in European economies means that there is no obvious alternative to the dollar, should we be so irresponsible and, yes, crazy as to allow the default of the U.S. government.

A worldwide financial meltdown is just one of the scenarios that become possible to imagine, since there is no other government with all of the requisite characteristics to serve as the world's lender of last resort: What is needed is adequate size relative to the world economy, enough financial flexibility to step in where needed, and the political will to do so. The United States has been that country since World War II, but the Europeans are demonstrating in their own current crisis that they are reluctant to act decisively even with the European Union itself.

Who will lose if there is a default? The first losers will be everyone with a stock or bond portfolio. Rising interest rates will put a major hole in the value of all of our retirement savings. Second, as economic activity inevitably drops in response, we will all suffer a second downward phase of the current recession. It would stop being called a "recession" and would merit the name "depression." It won't be pretty.

Who will win? It is fashionable for the "out" party to imagine that it will benefit from economic bad news in an election year. But it is hard to believe that conventional wisdom will be reliable, particularly if Republican intransigence is seen to have been a contributing factor. In short, nobody will win. Nobody at all.

How to get out of this fix? Certainly the easiest solution in the short run would be for Congress to pass the one sentence of legislation required to raise the debt ceiling. But if a solution "requires" multitrillion dollar spending cuts, then we should be careful what we wish for.

Rather than economic chaos, we would have a massive government-induced negative shock to an economy already teetering on the edge of a second downturn in activity. It is hard to believe that our politicians are competing with each other to see how far down this road they can go.

Were I advising a low-income country that had no choice but to listen to my advice, I would have a simple message: "You got into this mess by passing huge tax cuts over the past 10 years and starting two wars that clearly have gone as far as they are going to go in terms of achieving your goals. So just let those tax cuts expire next year and end the two wars, and you will have done more to reassure long-term investors than anything else you could possibly do. That will give you the room you need to make investments to start growing again."

But though Senate Majority Leader Harry Reid's plan does count savings from winding down the wars, House Speaker John Boehner's doesn't, and letting the Bush tax cuts expire doesn't seem to even be part of the discussion. You have to wonder why.

The opinions expressed in this commentary are solely those of Steven Kyle.

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