Debt crisis

Peter Diamond is professor of economics at the Massachusetts Institute of Technology (MIT) in Boston. He was awarded the Nobel Prize in Economics in 2010 for his work on the labor market. Notwithstanding his credentials Diamond's nomination as a board member to the US Federal Reserve by President Barack Obama was blocked three times by Congressional Republicans. He withdrew from the nomination process in 2011.

DW: Millions of people around the world are watching the fight over the US government shutdown, the debt ceiling and the health care reform with bated breath and trepidation over the consequences for the global economy, but ultimately can't comprehend why the US is veering toward the economic abyss. If anyone can explain this to rest of the world, it must be an American Nobel laureate in economics. So please go ahead.

Peter Diamond: Let's start with the debt ceiling because its potential impact of the failure to raise the debt ceiling would mean the US could not borrow more to continue its various payments for services and promised benefits and for interest on the debt. So the first thing to recognize about the debt ceiling is that it is not a common practice. It is something that does not exist in most countries.

Secondly it is a bit of an anomaly because the legislative process determines both spending and the parameters that generate revenues. The debt outstanding is the outcome of that process. So to have a debt ceiling is to have a second round around the spending and revenue collection process where in a sense there is a possibility of saying we have laid out these plans and now we are not going to carry them out even though they were properly legislated before. So a common call is to just eliminate the whole idea of the debt ceiling on the grounds that it doesn't play a sensible role in having good public policy.

What it does is open up from time to time the political process that goes with one side or the other threatening to not approve an increase unless there is some political change that they are in favor of. I view that as hostage taking. And I would hope the voting public would see it the same way. It is an extreme version of trying to get ones own political way rather than the normal process which inevitably involves significant compromise. So my view on that part is it is an unnecessary damaging part to the world economy, just the threat that it might happen.

But not being sure that something terrible will happen, but merely recognizing the possibility that something really terrible could happen is reason enough not to go anywhere near it.

Number two is the government shutdown. The budgetary process is an annual part of what Congress and the administration do. Working out how much to spend and how to divide that among different programs is an essential part of the legislative process. So we've had a bill setting total spending limits that has passed the House and we have had a bill with a different amount that has passed the Senate. The normal process would be a negotiation process between the two houses and settling on a level of spending that is some kind of compromise. That has not happened this time, but rather both are seeking political leverage.

Unlike the debt limit which plays no role in sensible policy design, obviously legislative spending and revenue is an essential government function. And the failure to have an early process of settling things is a common political outcome. Many things go better when determined ahead of time, but sometimes the politics around it result in waiting until the last moment before doing anything. And that always runs the risk of a glitch. So I view the shutdown as really unfortunate, as very expensive both in the services provided and also in the finances of the government, because this is not a money saver to have it shutdown. The federal employees will get paid for all of this whether they worked or didn't work.

Number three is a totally different political animal. The US has in some ways an outstanding and in some ways an abominable health care system. It's wildly expensive, it leaves millions without health insurance and that shows up very clearly in the health care and the health outcomes they get. The idea that the US would get closer to what happens in other advanced countries is to my mind a step in the right direction however you like or dislike the particular details.

The words we see how this is going to be destructive for the country strike me as laughable and also remind me of the fact that Republicans were saying the same thing about the creation of social security in the 1930s and that this was going to destroy the American freedom which of course it did not and it's a wildly popular program. And an improved delivery of health care would also be a wildly popular program and I think we will get that out of that legislation, provided we do systematic evaluations and reforms going forward. But the idea that doing nothing makes any sense and the idea that doing this would be terribly destructive don't pass the laugh test.

There appears to be some movement toward compromise now in Congress. How optimistic are you that the looming default can still be avoided?

That's a good question, because there is a real shortage of time. I had hoped that the compromise that would come out would be longer lasting rather than throwing us back into this process again as soon as very early next year. But with enough time the compromise that is being described in the press would easily pass both houses of Congress and be signed by the president.

Whether in either the Senate or the House there will be moves to delay or block the vote that could wrap it up easily in time before Thursday, I don't have a feel for the nature of the people that have the ability to do that. And whether there will be some particular senator who will slow the process down, I don't have an idea. On the House side it's all in the hands of the speaker and I expect that he will rise to the occasion. But that's an expectation just based on descriptions I have seen of what other people are expecting of him since I have never met the man.

Even if Congress reaches a last-minute deal to avert a default, it's not a solution at all and really only kicks the can down the road until early next year. What does this do to the standing of the US as the world's economic leader and to the role of the dollar as the world's reserve currency?

I don't think it does much actually. I think the harm is primarily short run. Just as the previous fight over the debt limit visibly harmed the economy in the short run, but had no lasting effect after that. While US credit standing was downgraded I saw essentially no effects coming from the downgrading. It certainly did not have any visible effect on interest rates.

The issue is what happens with the political process as the political process is shooting the country in the foot. My hope is the next election will take us away from the current dysfunctional pattern of the particular member of Congress and of particular divisions in parties. There will be I expect around the world a sense of wait and see. Having caused significant harm, having frightened a lot of people - me included - the question is will the political process come out of it better than before. We'll get a better read on that early next year.

And I think until it becomes clear that the US remains so politically dysfunctional, there will not be any movement away from the role of the dollar around the world and the role of the US treasury debt. Even if there is a brief default - and nobody is expecting more than brief - the impact will come through the functioning of the capital market, not because there are going to be significant losses in value on the US debt because it is not paid.