A craze is sweeping the nation, the idea that failing to raise the debt limit would not be an abomination. The most outspoken supporter of this view in Congress is Rep. Ted Yoho (R-FL), who told the Washington Post on Friday that “it would bring stability to the world markets.”
A weaker version of this position is one more commonly held among conservatives: that the Treasury Department can just prioritize payments to bondholders, that those bondholders will be pleased and that Treasury bills will continue to roll over smoothly. And you know, the federal government is too big anyway, so not spending any money beyond what’s coming in from taxpayers and what’s being seized from holders of preferred stock in Fannie Mae and Freddie Mac is probably a great idea.
Fortunately, cooler minds seem to be succeeding for now, and Speaker Boehner’s plan to raise the debt limit for six weeks could provide some temporary relief. But I would not be surprised if in six weeks we were right back where we are now. In that case, the view that crossing the X date is no big deal will almost certainly make a comeback.
"Both the moderate and the extreme renditions of this view are dangerous."
Both the moderate and the extreme renditions of this view are dangerous. First, the idea that financial markets are pleased by the way in which the Congress and the president are setting budget policy is one that must have originated in Cloud Cuckoo Land. In the summer of 2011, Congress came dangerously close to breaching the debt limit, and a downgrade on U.S. sovereign debt quickly ensued. As Standard & Poor’s put it back then: “More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.”
Although we are at least a week away from the X date, when Treasury runs out of borrowing capacity, markets have already started to express similar discontent. The interest rate on Treasury bills that the government pays to borrow has risen to its highest level since 2008, reflecting concern that the government will fail to meet its obligations to bondholders. Under the Yoho paradigm of financial markets, these rates should, of course, have gone negative by now: we’re almost there, our spending is almost controlled, we’ve almost succeeded at keeping the debt limit in place! The cost of insurance against a U.S. default has also soared; a one-year U.S. credit default swap is now ten times as expensive as it was on Labor Day. Again, not exactly a vote of confidence for Yohoism.
Now, the second camp of people less than concerned about hitting the debt limit is certainly more reasonable. Martin Feldstein, the George F. Baker Professor of Economics at Harvard University and formerly chairman of Ronald Reagan’s Council of Economic Advisors (disclosure: my Ph.D. adviser), certainly not a Yohoista, wrote the following in a widely circulated email this week: “The government may not be able to separate all accounts into "pay" and "no pay" groups but it can certainly identify the interest payments. An inability to borrow would have serious economic consequences if it lasted for any sustained period [.]”
This may be true, but it requires tremendous faith in Treasury’s ability to adjust its IT systems to a whole new world. Especially in light of the widespread problems with the rollout of the Obamacare exchanges this past week and a half, that faith is likely to be shattered quickly, and the magic-carpet ride of payment prioritization will probably be rocky, not romantic or rosy.
"But even if it were true, emphasizing the technical feasibility of this option distracts from the 'serious economic
consequences' it would entail."
But even if it were true, emphasizing the technical feasibility of this option distracts from the “serious economic consequences” it would entail. During the 2011 debt-ceiling crisis, consumer confidence dropped to its lowest point since the darkest days of the financial crisis, and a similar pattern has started to unfold now: confidence levels have been going downhill rapidly. Meanwhile, indices of economic policy uncertainty spiked to their highest point ever. The increase in policy uncertainty since 2006 has been estimated to have caused a decline in production of 2.5 percent, and a rise in the unemployment rate of between 1 and 2 percentage points. Doing even more damage by taking the country even further down the road to default would be a terrible, terrible idea.
There is also a more direct negative impact on the economy that would accompany payment prioritization. The federal government would have to make big cuts in its regular outlays to eliminate the budget deficit instantly, and reduce its payments by a third. Individuals who depend on entitlement payments, federal workers who receive their paychecks from the government, and a wide variety of others who engage in transaction with the federal government would be hit by big financial setbacks. These would sum up to a total fiscal drag of 4.2 percent of GDP (annualized), according to Goldman Sachs, throwing the U.S. right back into recession. And that is before financial markets start panicking, equity markets crash, and credit dries up.
Well then! That sounds pretty bad. Like a no go, Ted Yoho. Let us raise the debt limit for a few weeks now, and please promise us not to start saying the same things again in late November.
-Stan Veuger is a resident scholar at AEI. His academic research focuses on political economy and applied microeconomics.