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The United States, once regarded as the most economically competitive nation in the world, has fallen to 4th place, according to the 2010-2011 Global Competitiveness Report published by the World Economic Forum, the folks who organize the prestigious Davos wonk fests.

Only two years ago, the U.S. ranked No. 1 in the comprehensive assessment of the competitive strengths of all the world’s nations. In last year’s report, the U.S. fell to No. 2, surpassed by Switzerland. This year, the world’s largest economy was humbled yet again, falling behind Sweden and Singapore, with Germany nipping on its heels.

While the U.S. still possesses great strengths, in particular the size of its domestic economy, the flexibility of its labor markets and its capacity for innovation, major weaknesses have intensified. The report cites growing distrust of politicians, questions about the government’s ability to maintain arms-length relationships with the private sector, and the wastefulness of government spending. But dysfunctional macroeconomic policy ranks as the biggest concern of all. States the report:

A lack of macroeconomic stability continues to be the United States’ greatest area of weakness (ranked 87th). Prior to the crisis, the United States had been building up large macroeconomic imbalances, with repeated fiscal deficits leading to burgeoning levels of public indebtedness; this has been exacerbated by significant stimulus spending.

How does public indebtedness impact national competitiveness? First, it is necessary to understand what the Global Competitiveness Report means by competitiveness: “We define competitiveness as the set of institutions, policies, and factors that determine the level of productivity of a country.” The level of productivity dictates the level of prosperity that a country can sustain, as well as the rates of return on investments in physical plant, human capital and technology. A more competitive economy will likely grow faster in the medium- to long-run.

Continued budget deficits and high public debt crimp productivity in several ways. First, they reduce fiscal flexibility. Government has fewer resources to invest in productivity-enhancing infrastructure, education and public health, or to apply as fiscal stimulus during downturns. Second, as governments borrow more, interest rates will tend to rise, thus driving up the cost of capital for private business.

Also, the report notes, these effects can be exacerbated by consumer and business expectations. “Because taxes will most likely have to be raised in order to repay debt, economic agents will adapt their growth expectations, investing less and saving more. Taken together those factors may lower growth, making it even more difficult to repay debt in the future and potentially leading to a vicious cycle.”

For investors appraising the long-term future of U.S. Treasuries, here is the takeaway: There is a feedback loop between deficits/debt and economic competitiveness. Growing deficits reduce a nation’s productivity and competitiveness over time. Lagging productivity/competitiveness translates into slower economic growth, weaker tax revenues and even bigger deficits.

That feedback loop is masked right now because interest rates are so low. But it will kick in full force later this decade as the global capital glut turns to global capital scarcity and interest rates begin to climb.

Disclosure: No positions

Source: America's Competitive Edge Is Eroding