Debt Downgrade Weakens U.S. Stature Abroad

A broker watches screens displaying the German stock index DAX at the stock market in Frankfurt, Germany, on Monday, where the stock index fell after the opening of trading. i i

A broker watches screens displaying the German stock index DAX at the stock market in Frankfurt, Germany, on Monday, where the stock index fell after the opening of trading. Michael Probst/AP hide caption

itoggle caption Michael Probst/AP
A broker watches screens displaying the German stock index DAX at the stock market in Frankfurt, Germany, on Monday, where the stock index fell after the opening of trading.

A broker watches screens displaying the German stock index DAX at the stock market in Frankfurt, Germany, on Monday, where the stock index fell after the opening of trading.

Michael Probst/AP

In the rest of the developed world, the downgrade of United States debt is seen as an important marker in a long process that is likely to harm both the world economy and America's reputation as a fiscal steward.

"There's real fear that, given the mounting challenges facing the administration and the standoff in Congress, this could really weaken U.S. influence and the U.S. role in the world," says Simon Tilford, chief economist at the Centre for European Reform in London. "For most Europeans, that's not a prospect they welcome."

Already, the downgrade is driving down international stock markets. It's also having a cascading effect in terms of government policies and economies in other nations. The worries about U.S. debt are exacerbating a crisis in the eurozone that has led to multiple bailouts of weaker economies such as Greece.

"The American downgrade has had an immediate effect on the Europeans," says Thomas Kleine-Brockhoff, senior director of policy programs at the German Marshall Fund, which promotes cooperation between North America and Europe.

European leaders came out of a summit just two weeks ago believing they had gone a long way toward addressing the euro debt crisis, Kleine-Brockhoff says. But "their own mistakes" and the S&P downgrade have led to a sudden reversal of policy positions stated just last week.

Underlying Problems May Be Worse

Foreign observers say that the problem with the U.S. is not so much the Standard & Poor's decision to downgrade U.S. debt last Friday. That move was widely anticipated. Rather, they say, the issue is the lack of political will demonstrated by the debt-ceiling debate.

"While internal opinion about the debate in the U.S. was that we dodged a bullet, we got it done at the last second, the opinion here is that the damage has been done," says Kleine-Brockhoff, who is in Berlin.

That damage, he says, takes the form of a lack of confidence in the U.S. political system and its ability to reconcile differences of opinion about whether debt should be addressed through increasing revenue levels or spending cuts alone.

"Now, of course, the supercommittee has to address the underlying problems," says Norbert Walter, a former chief economist for Deutsche Bank. He was referring to the committee created by the debt ceiling legislation to come up with a deficit reduction package of $1.5 trillion. "And the underlying problems are much more divisive."

Dampening Effects

Leaders and markets in both Europe and Asia are now nervous that the U.S. will not take the steps necessary to put its fiscal house back in order. China's official news agency said Saturday that the United States must "cure its addiction to debt."

If the U.S. does "learn to live within its means," as the Chinese insist is necessary, it will not be alone. Europe is also entering an era of retrenchment borne out of the need to address excessive levels of debt.

Countries such as Japan, Britain and France — as well as the struggling southern European countries including Greece, Italy and Spain — are either tightening their belts or soon will be, says Walter, who is now managing director of Walter & Toechter, a consulting firm in Germany.

"If everybody is moving in this direction over the next year or so, we will have a dampening effect on the world economy," he says. "We will have to accept that the world will be on a considerably lower growth trend rate in 2012, and for a number of years, in order to get those imbalances corrected."

The Savers Of The World

The Chinese hold about $1.2 trillion in U.S. Treasuries, as well as about 2 trillion in dollars. They are understandably nervous about the long-term value of those assets.

If they are left holding paper of diminished value, they have only themselves to blame, argues Tilford, the economist at the Centre for European Reform. China bought U.S. assets in part to hold down the value of its own currency, the yuan, and so prop up its exports.

"No one has been forcing the Chinese to accumulate U.S. assets," Tilford says.

Walter agrees that China and other countries that have been running trade surpluses, including Germany, are likely to suffer if the U.S. does cut down on purchases of consumer goods and other products.

But he said that is not sufficient reason to dismiss the fears expressed by China, the largest foreign holder of U.S. government debt — or those expressed by major domestic investors in Treasuries, such as pension funds.

"If the savers of the world, who have provided their savings to the U.S., feel that the policies of the U.S. amount to not paying back the loans that have been granted, that is a very relevant concern," Walter says.

Still Some Advantages

Despite Friday's downgrade, the U.S. is having no immediate problem selling Treasuries. And, even though Japan has seen repeated downgrades during its years of economic malaise, it's still able to borrow cheaply.

"The debt level of the U.S. is not materially higher than that even of the AAA-rated countries in the European Union," says Daniel Gros, director of the Center for European Policy Studies, a think tank in Brussels.

Many foreign economists note that despite its challenges, the U.S. remains a good investment over the long haul. Unlike struggling countries such as Greece, Italy and Spain, America has control of its own currency. "The debt is not crippling, given its own economic prospects," says Tilford.

The U.S. also has demographic advantages over its major economic competitors. By 2015, the U.S. will be the only developed nation where the working-age population is not starting to shrink.

"The U.S. maintains a higher potential growth rate — even if only for demographic reasons — than most EU member countries, and certainly higher than that of Germany, whose working-age population will soon start to decline rapidly," Gros says.

Political Worries Persist

But foreign observers worry that the U.S. will squander its advantages, that political polarization will prevent the nation's leaders from taking the necessary fiscal steps. They worry that the debt-ceiling debate represents only a preview of future arguments about taxes and entitlements.

Leaders in few other countries can point to such immediate and practical steps that might be taken to address the nation's indebtedness, says Walter, citing an increase in the gasoline tax as just one example. Yet all such roads are blocked politically in the U.S., he says.

Tea Party Republicans will insist that the revenue side of the ledger is "sancrosanct," Walter says, and insist that the debt be addressed through entitlement cuts, while "middle-of-the-road Republicans" and Democrats will block such a course.

"You can listen to educated people in the street or European leaders," says Kleine-Brockhoff. "There's no confidence that the U.S. political system can deliver in the way that markets need to see them deliver."

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