Newspapers carry alarmist headlines about the partial shutdown of the US government because of a budget impasse over Obamacare. Yet, the markets have moved only slightly. Veteran traders yawn with amusement: they know the US has had such shutdowns before, and none lasted long or inflicted significant damage.
Yet, this is not just one more shutdown. It is the first act in a long drama that, over the next 20 years, will upend historical traditions and challenge the Idea of America. Till now, the US government has been spending around 8% of GDP on three welfare items: Medicare (for the aged), Medicaid (for the poor) and Social Security (for retirees).
But demographic change — retirement of the baby boomer generation and ageing of the population — looks like it will make such spending skyrocket to 19-20% of GDP in 25 years.
Electoral dividend
Obamacare will contribute only a couple of percentage points to this rise. Medicare will be the dominant contributor to the coming welfare explosion. Not even the most strident anti-Obamacare politicians dare call for curbing Medicare, which benefits the biggest vote bank of all: the aged.
In the next 20 years, welfare entitlements must be slashed drastically —which looks politically impossible —else, the US will have to raise taxes hugely and become an European-style welfare state. This will mean the end of its historical tradition of rugged individualism and minimum government. It will mean the end of US sneering about deadbeat Europeans and their dependence on government handouts.
It will change the US beyond recognition. This helps explain the rise of the Tea Party, a motley group covering a range of Americans from white supremacists to libertarians. What they have in common is visceral opposition to high tax-and-spend policies that they see as an European disease. Many of them view Obamacare as a monster that must be killed at birth.
Government closed for Tea Party
The Tea Party accounts for at most a quarter of all voters. Foreigners are amazed that a small minority like this can shut down the government. But Tea Party has developed such a strong, ideological and well-organised base that it has captured the entire Republican Party.
Tea Party candidates have repeatedly defeated venerable moderate Republicans in party primaries. The Tea Party wants none of the compromise and fudge that normally mark legislative outcomes in a situation where the Republicans control the House of Representatives and the Democrats control the Senate.
More potentially devastating than the partial shutdown of the government is the threat of the Republicans, at the behest of the Tea Party, to refuse to raise the debt ceiling of the government. Unlike in India, US law sets a ceiling on the amount the government can borrow, and whenever that ceiling is approached, Congress has to authorise an increase.
The current ceiling will be reached in late October. If no compromise is reached, hitting the debt ceiling will trigger the most draconian spending cuts. The government will have to limit all future spending to incoming revenue, balancing its budget with zero flexibility. This will mean an instant spending cut of 4% of GDP, causing a deep recession. Worse, it may mean a default on gilts, causing more havoc than Lehman\’s collapse did in 2008.
US gilts are the lynchpin of the global financial system. They are the ultimate riskless asset, the base for calculating risk premia of other financial assets. The US government could guarantee its creditors that it will give debt service priority over other spending.
Back to business?
But this would be politically tricky: can politicians justify paying interest to Chinese bondholders while cutting off pensions to aged Americans? This may not even be constitutional.
Bill Gross of Pimco, the biggest bond fund, says there is no chance of US default. He and many others say that politicians and financiers will find some way of ensuring US debt service even if the Tea Party prevents any increase in the budget ceiling.
Of the many ways out being discussed, the most amusing is for the government to mint a trillion-dollar platinum coin, and deposit this in the Treasury. US law prohibits the government from borrowing above the ceiling without permission. But another law allows the government to issue platinum coins without limit.
This law aims to meet the modest needs of coin collectors, but Obama could use this as a loophole to get unlimited spending power. This will be political theatre. The real-life drama is a separate, much deeper one: the wrenching end of America as the land of rugged individualism, and its evolution into European-style welfarism.
History shows that once a big welfare scheme starts operating, it cannot be reversed — that would produce too many immediate losers to be politically feasible. So, whatever the Tea Party tries, demography will ultimately win the day for welfarism. An ageing population will protect everrising benefits for older people. Just as in Japan or Europe.
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Mr Aiyar,
I faithfully read your columns and blogs every week, and I agree with most of your opinions. I want to comment here because this is one time I disagree with you. I think your view this time hasnt presented a balanced view of the situation.
It is true that the Democrats do push for welfare, and it is sad to see the weakening of the Republican party. The Republican party is more focused on tax rates than governance. The Tea Party might have the message of fiscal responsibility, but it has been corrupted by the tactics that it has taken, and their focus on other social issues like immigration and birth control. The shutdown cost the economy 24 billion dollars (by some estimates), and a default would have added to the deficit rather than cut from it due to increased borrowing rates. How can that be a message of fiscal responsibility? They are behaving like suicide bombers and not mature adults who want to solve a problem.
Your points about welfare state is well taken, and there is agreement on both sides that the entitlements need to be fixed. Republicans just are paying lip-service to this and not doing anything precisely because they dont want to loose votes. They are focusing on Obamacare, which while flawed in many respects, is trying to address the insane costs of health care in the US. They want to defund it without offering a solution. Free markets dont work in health care because ERs have to attend to patients whether they have insurance or not. Those costs are transferred to other patients. Its not really a free market, where consumer pays for it if needs to. Like roads and bridges, getting treatment is not optional. Republicans dont have an answer to this. Indeed, the Heritage Foundation that backs the tea party came up with the idea with Gov. Romney implemented. Now they want to defund it.
If this brinksmanship stops they can help correct what is wrong with entitlements and Obamacare. The US individualism has been tremendously helped by the govt investments in infrastructure and research. Refocussing on that would only make the economy stronger. It is the governments responsibility to provide an infrastructure for people to build on. That has always been the basis of US’s strength