US debt

Kenneth J. Arrow is professor of economics emeritus at Stanford University and winner of the Nobel Prize for Economics in 1972. He is the youngest Nobel Laureate to have been awarded the prize in economics. Arrow also served on the White House Council of Economic Advisers under President John F. Kennedy.

Deutsche Welle: What many people around the world probably still deem impossible and what for many experts seemed unrealistic just a few weeks back could become reality. The US, the world's biggest economy and strongest power, may be unable meet its debt payments within days. How big is the risk that the US will in fact default?

Kenneth Arrow: I think it's unlikely. I think that the pressures from the financial sector are going to be sufficient to avoid this. I have seen proposals such as the one by Republican Senate Minority Leader Mitch McConnell to somehow dodge the issue. I have a feeling that's how it is going to end up, but you can't be 100 percent sure. It could be that they somehow have a deadlock in which case the debt limit will be not raised. There's a 10 percent chance that could happen.

With each day of failed political talks in Washington to raise the debt limit the US is edging closer to default and the finger pointing between Democrats and Republicans intensifies. Is the impression one gets from abroad correct that the political players are worried more about not blinking too early and scoring a political victory than about avoiding a possible fiasco?

There are a lot of factors at work here and one I think is ideology. There are some people in the Republican Party who have said they wouldn't vote for an increase in the debt limit no matter what concessions are made. They just feel the government is too big and we should cut it back and this is a very convenient weapon. So it's not entirely just about political advantage.

There is that of course in every political confrontation in every democratic country that's true. But the same Republican Minority Leader, Senator McConnell, said a few months ago my main aim in everything is to make sure that President Obama is a one-term president. So he said explicitly that political advantage is what he is concerned about. So I think there is a mixture of reasons.

Couldn't they just detach the political issue over taxes and spending for the time being and raise the debt limit simply to avert a default which is arguably in no one's interest or is this too naïve?

Of course. The whole thing to my mind is somehow a crazy idea. We have a budgetary process. We have a budget and it was passed earlier this year. Why isn't that the end of the story? Why is there a separate vote on the debt limit? When you have a budget that has certain implications for the debt you don't know exactly what they are because tax revenues at least are uncertain. So when you pass a budget you have projections, but you don't actually know what's going to happen. So the question is why don't you just pass the budget and if you need to borrow you borrow. That's all there is to it. So why is there a second vote?

This is an old thing and I don't know how far back this principle goes. But typically the debt limit has been automatically raised. It's not really controversial. So the idea that we have a vote on the debt limit is crazy in my opinion. You make a budgetary decision, you have your debate and that's it. But once it's there it's used as a political weapon and people don't want to abandon it. It's the same with the filibuster rule in the Senate, but I won't go into that.

There is disagreement over the severity and the consequences of failing to raise the debt limit or an actual default. How bad would the failure to raise the debt limit be in concrete, practical terms?

It would be bad obviously, but more for symbolic reasons. The possibility of a default is very well known and that means that the immediate consequences would be much less severe than if there is a sudden collapse coming out of nowhere as it happened for instance with the subprime mortgage fiasco. The financial system has been adjusting to this.

Second, the fundamental soundness of the United States is not really in question. The United States obviously has an edge by being able to borrow as a safe borrower and as the place where foreigners park their money in times of trouble. And we see that currently by the fact that the interest rate of US government debt is extremely low in spite of the financial problems. In fact if you go back a number of years you find that the United States has been borrowing money at low rates of interest even during prosperity and investing abroad at relatively high returns because the US is considered safe.

Now this is going to shake that somewhat. Not too much, because everybody knows that fundamentally there is no real problem and it's just a political issue. Still it does mean that the United States is a less stable country politically than was expected and it will have consequences.

So how would this play out?

I think the first reaction would be to cut something else. Social security would be possible target because it would be a very big political signal. But at some point there will demands as to why shouldn't the holders of government bonds suffer if the poor, old people are suffering. That will be the next in line. I think at that point or even before that you will see a big rise in interest rates.

Government debt will start going down and of course this will affect the holdings of banks throughout the world. So I suppose there will be a tightening of the belt and I imagine there will be spillover to private enterprise. In any case interest rates will rise, that's a clear consequence and when interest rates rise that is going to affect investment in the United States and abroad probably.

My feeling is there would be lowering of the American economy and probably some of the European economies too because the banking systems are so interlinked. Probably China will be the net gainer in all of this. They will be getting more money on the bonds they hold on the United States.

Interview: Michael Knigge
Editor: Rob Mudge