Simon Johnson: Powerful rich more harmful to US than ratings downgrade

The US has a fiscal crisis, but not the one that everyone is talking about. Standard & Poor's proved beyond a reasonable doubt that the US still has the world's pre-eminent reserve currency. When shocks hit - and investors have no idea who or what might be next in line for a downgrade - they buy US government securities.

Downgrades don't usually have this effect. For example, if S&P or other rating companies downgraded France, that would set off a crisis within the euro region - pushing up interest rates on French government debt, undermining euro-area banks, and perhaps putting pressure on the fabric of the European Union itself.

With a one-notch downgrade of the US Government, on the other hand, S&P inadvertently lowered the US's borrowing costs, both at the federal level and for homeowners who refinanced their mortgages.

The US's fiscal problem is not that the market questions the country's ability to pay its debts. The willingness to pay was clearly proved by the outcome of the debt-ceiling debate, when even a majority of Tea Party adherents in the US House of Representatives voted to lift the ceiling (though it would have passed without their votes).

The US most definitely does not have the kind of solvency crisis experienced by some emerging markets and now, for the first time, parts of Western Europe. Instead, the crisis has two dimensions. First, there is a growth crisis.

My MIT colleague, Daron Acemoglu, in a blog post on the Harvard Business Review website, makes the point vividly. In his view, one percentage point extra growth per year for the next 20 years would fix the US's budget problems.

If we could manage to increase our growth rate from 2 per cent a year to, say, 3 per cent over the long haul, that would greatly boost average incomes, as well as tax revenue.

Acemoglu also argues that the US economy can grow through innovation, but only if US policies foster more basic scientific research and more effective commercialisation of technology. The US also needs to improve its patent system and allow more skilled foreign workers into the country, Acemoglu says.

The general policy mood may be shifting in this direction. Jeb Bush, the former Florida Governor, and Kevin Warsh, a former Federal Reserve Governor, made similar points in a Wall Street Journal op-ed last week. Both felt the need to repeat the mantra of the day, "Cutting spending is essential," and then quickly made the right point: "But we will never cut our way to prosperity."

Restoring growth is not easy because of a second, more debilitating element - a paralysing fight over the distribution of income, in which powerful people can block the Government from doing anything sensible if that is against their narrow interest.

This dynamic can be seen in the debate over who will foot the bill for the 2008 financial crisis, which caused a deep recession that pushed up the federal Government's medium-term debt by about 50 per cent of gross domestic product.

To control future debt levels, someone has to pay for that fiasco. But people in high-income brackets have dug a brilliant defence against tax increases in the form of the Tea Party. Backed by 30 per cent of the population, this group exploits the broad design of the US Constitution, which gives well-organised minorities an effective veto power over major policy changes. The result is that, instead of letting President George W. Bush's tax cuts for the rich expire, we are headed for deep spending cuts that disproportionately affect the less-well-off.

More generally, powerful lobbies have amassed great privilege in the political system, and they can't be easily moved from their positions. For example, Jeb Bush and Warsh say, quite reasonably, "If banks are 'too big to fail,' they are too big. They must be allowed to succeed or fail on their own merit, without any hint of government support."

But there is precisely no chance that Congress, the Federal Reserve or the executive branch will end the subsidies that undergird big banks, and that keep them in business through essentially free insurance against downside risk.

Acemoglu and James Robinson of Harvard University have a forthcoming book, Why Nations Fail: The Origins of Power, Prosperity, and Poverty, that attributes economic success to political institutions that support innovation and growth.

The US has done well over 200-plus years in most of the areas Acemoglu and Robinson stress. But the country now seems to be in the grip of an oligarchy that is bent on protecting its position at the expense of spending for the public good on things like education and scientific research. Nations frequently fail when powerful interest groups block change. If this is the US situation, it's more serious than any rating company's view on debt levels.

* Simon Johnson served as chief economist at the International Monetary Fund in 2007 and 2008 and is now a Massachusetts Institute of Technology professor and a senior fellow at the Peterson Institute for International Economics.