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Sanity will prevail in the US but Europe remains gripped by madness

Obama is nearing a compromise with Congress over a plan that will save the US from defaulting on its

There is more economic trouble brewing in the United States and Europe. In an apparently wilful act of sabotage, US legislators have decided to bring their country to the edge of financial disaster for no good reason. The 2 August deadline to increase the US debt ceiling requires congressional approval and, just days away from that date, there is still no deal between Republicans and Democrats as we go to press. As the chairman of the Federal Reserve, Ben Bernanke, warned on 14 July, in testimony before the Senate banking committee, failure to raise the ceiling would be "calamitous" to both the US and the world financial systems. Bernanke made it clear that the Fed would not be able to offset the impact of the damage.

President Barack Obama and his treasury secretary, Timothy Geithner, have issued warnings about the dire consequences resulting from a failure to act, as have a host of business leaders. The effect of not increasing the debt ceiling would be to lower the US's credit rating, raise government borrowing costs and lower growth. In addition, a failure to act would put the US into default, which in turn would increase consumer mortgage rates, car loans and credit card repayments. In short, failing to raise the debt ceiling would be economic suicide.

Smart options

Raising the debt ceiling has been normal practice for nearly half a century. It has been increased 74 times during that period and, significantly, was raised more under Republican presidents than it has been under Democrats. Ronald Reagan raised the ceiling 18 times when he was in office. The four Republicans who currently hold congressional leadership positions - Speaker John Boehner, the House majority leader, Eric Cantor, the Senate minority leader, Mitch McConnell, and the Senate minority whip, Jon Kyl - voted for increases to the debt limit during George W Bush's presidency without making any demands for spending and tax cuts. All four voted for increases in the debt ceiling in May 2003 (+$900bn), November 2004 (+$800bn), March 2006 (+$781bn) and September 2007 (+$850bn).

So what has changed? Politicians on the right now believe that they are reflecting public dissatisfaction with the poor state of the economy. Unemployment stands at over 9 per cent, and it was the continuing crisis that led to Republicans taking control of the House of Representatives in last November's midterm elections. Many of the freshman Republicans have a strong affinity with the Tea Party movement and have been pushing for sharp cuts in spending, ruling out tax rises of any kind and calls for a constitutional amendment mandating balanced budgets. (I guess they didn't notice that the private-sector firms - including banks, car manufacturers and insurance companies - survived only because of a huge infusion of public-sector funds.) Astonishingly, most Republican voters don't believe that failure to raise the debt ceiling will be damaging. They are wrong.
On 19 July, the former president Bill Clinton intervened in the debate by suggesting that President Obama could resolve the debt crisis by making use of the 14th Amendment of the constitution. Clause four of the amendment, passed after the end of the civil war, reads: "The validity of the public debt of the United States, authorised by law, including debts incurred for payments of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned."

Clinton argued that he would use this option "without hesitation, and force the courts to stop me". Nevertheless, he seems to believe that the crisis will be resolved before the August deadline. "It looks to me like they're going to make an agreement, and that's smart." Adam Winkler, a law professor at the University of California, Los Angeles, said of the 14th Amendment option: "Without any clear case law about the debt ceiling in particular, no one knows exactly how the courts would rule on that issue . . . If [Obama] wanted to continue to service the public debt, he'd probably get away with it."

But then, on 19 July, the president welcomed what is known as the "Gang of Six" proposal, a deficit reduction plan put forward by a bipartisan group of half a dozen senators. The two-step plan would introduce legislation offering immediate cuts and a second bill to enact comprehensive reform. It includes an initial $500bn payment towards deficit reduction, discretionary spending cuts, a reduction in marginal income taxes and social security reforms. "We're in the same playing field," Obama said.

Stressed out

The reaction of the bond markets suggests that they don't believe there will be a default. The graph (below) plots ten-year US bond yields, which have fallen slightly over the past week to below 3 per cent. It also plots ten-year bond yields for six European countries - Greece, Ireland, Italy, Portugal, Spain and the UK.

Blanchflower graph

Yields in the UK have followed those in the US very closely; they were low before the general election last year and remain low now. On the basis of this graph, there is little evidence that the markets were demanding that the Conservative-Liberal Democrat coalition had to act as it did to cut the deficit so harshly. It is abundantly clear that the UK is not Greece.

However, there is evidence of contagion in three peripheral eurozone nations - Greece, Ireland and Portugal. In these countries, bond yields have risen to historic highs over the past year or so. And in recent days, yields have risen markedly in Italy and Spain as the crisis spreads, driven by the publication on 15 July of stress tests on European banks. Once again these tests weren't very stressful, persuaded nobody and merely added to the pain the European Central Bank had already inflicted when it raised interest rates. The German chancellor, Angela Merkel, also dashed hopes that there would be a restructuring of Greece's debt, even though the IMF warned this month of the worldwide consequences if the eurozone debt crisis is not resolved quickly. It looks like sanity will prevail in the US, but it may be too late for Europe.

David Blanchflower is NS economics editor and a professor at Dartmouth College, New Hampshire, and the University of Stirling

David Blanchflower is economics editor of the New Statesman and professor of economics at Dartmouth College, New Hampshire