Since the time of the Founding Fathers, U.S. leaders have believed in the concept of American exceptionalism, that the U.S. is a special country with a special mission. It is a notion that continues to this day. And when it comes to the threat its deteriorating national finances present to the world economy, the U.S. is truly exceptional. That danger was finally made clear by Standard & Poor’s on Monday, which changed the outlook on its U.S. sovereign rating to negative – in other words, the S&P is threatening to downgrade the U.S. from its traditional triple-A status. The implications of this move are incredibly far-reaching. No, it doesn’t mean the U.S. in on the verge of a debt crisis. But it does mean the world can’t act like an elephant isn’t in the room. We’ve seen a debt crisis grip Europe and worries mount over the financial state of Japan. Those problems are scary enough. But when it comes to terrifying debt-crisis scenarios, the U.S. stands in a universe all its own.
That’s not because the U.S. debt burden is the biggest – Japan’s government debt is more than twice as large, relative to its GDP – but because of the exceptional role the U.S. plays in the global economy. A debt crisis in Portugal could send ripples of uncertainty through world financial markets, and if a larger country like Spain fell into crisis, those ripples could prove mighty destabilizing. But U.S. debt runs the risk of crashing the entire operating system of the global economy. Here’s what I mean:
Not only is the U.S. the world’s largest economy – by far – but it also dominates the global monetary system. In many respects, the entire architecture of global finance is built upon the U.S. economy. Its capital markets are the most liquid. The dollar is the world’s No. 1 reserve currency and the primary one used in foreign exchange transactions and trade. Countries like China and Japan have their national wealth stored to a great degree in U.S. debt. When investors get nervous, they rush to U.S. dollar–based assets, and especially U.S. debt. The perception has always been that the U.S. is the ultimate safe haven. Even as its financial condition sickens, that perception remains. Despite a dramatic increase in U.S. deficits and debt in recent years, the country has still been able to borrow at exceptionally low rates. In other words, the U.S. has benefited tremendously from its economic exceptionalism.
Now let’s speculate on what would happen if that perception fundamentally changed. U.S. Treasury securities would be seen as riskier and would therefore become less attractive. Interest rates would rise in the U.S. as a result, not only making it harder for the government to finance budget deficits and debt, but also raising borrowing costs across the economy, slowing investment and consumption. The U.S. dollar would weaken, undermining the value of currency reserves around the world and speeding us along to the day when the dollar is no longer the world’s premier currency. All that would be destabilizing enough. It would likely mean slower growth in the world’s largest economy, deteriorating living standards for Americans, and thus slower growth for the entire world economy.
But the bigger problem would be, What would take America’s place? The U.S. is the standard by which risk is assessed in financial markets. If the U.S. isn’t a safe haven, then what is? And what country’s currency and capital markets are deep enough to accommodate the world’s wealth if America’s can’t? Here’s how Mohamed El-Erian, chief executive at PIMCO, put it on a blog post on the Financial Times website on Tuesday:
The world looks to America for a range of “global public goods” — including the reserve currency, the deepest and most liquid government debt markets, and the “risk free” standard. With no other country able and willing to step into this role, the result would be global efficiency losses and a higher risk of economic and financial fragmentation…The time has come for the US (and other advanced economies) to take better control of its fiscal destiny—for the sake of American society and for the well being of the global economy.
Even though America’s exceptional role in the world economy makes its debt situation exceptionally dangerous, that role also apparently gives the U.S. exceptional protection as well. In theory, the S&P warning is a signal that the U.S. is not exceptional, that if it doesn’t get its financial house in order, it will face downgrades just like those of Greece, Spain and Japan. But the markets told us something very different. Treasurys weakened immediately after the announcement, a sign that investors were selling them, but then quickly recovered their strength. What’s that, you say? Yes, rather than scaring investors away from U.S. debt, investors actually bought U.S. debt after the S&P warning. And the reaction from some major U.S. bondholders showed little concern about America’s financial standing. “We continue to believe that U.S. Treasurys are an attractive product for us,” Japanese Finance Minister Yoshihiko Noda told reporters.
Sound crazy? Not really. The world has a lot at stake in the continued stability of the American economy, and thus every incentive to keep U.S. debt from roiling the world economy. This gets us back to the exceptional position of the U.S. in world finance. With nothing to replace the U.S., the country is getting exceptional treatment from the global economy.
It seems to me that U.S. policymakers have been banking (perhaps subconsciously) on this very outcome – that the U.S. is simply too exceptional to face dangers other nations could never avoid. They’ve been acting this way. The U.S. is the only heavily indebted developed economy that doesn’t have a credible plan to control deficits and debt. (Japan doesn’t either, but because of the need to soften the blow from last month’s devastating earthquake, we’ll give Tokyo a pass here.) In other words, the U.S. is counting on being like AIG or GM and acting as if it is too big to fail.
Is that true? American exceptionalism will give Washington an exceptional opportunity to fix its financial mess without suffering the consequences of other debt-heavy nations. But what if the U.S. fails to grasp the opportunity? Can the U.S. and the world economy escape the fallout? Now that would be truly exceptional.