What Happens If Government Debt Ceiling Isn’t Raised? 2 Things That Might, 1 That Will, and 1 That Won’t

Anybody who tells you they know exactly what’s going to happen if Congress doesn’t raise the government debt ceiling before next week is just making it up.  Reality is we don’t know for sure.  As Brad Delong notes (and Krugman and Nick Rowe), economists don’t even have nicely worked-out theoretical models of what happens if the government defaults.  It was just never considered.

Obviously, the devil is in the details. A lot depends on how the Congress deals with it  – the details of any “deal”. Many of the “plans” that have been floated on Capitol Hill to “deal” with the debt ceiling would most likely have consequences not much different from defaulting and not raising the ceiling at all.

And a lot depends on how millions of people think other millions of people will deal with it.  Another reason we have no good prediction of the consequences is because there are millions of investors worldwide involved. And each of them is making decisions based on what they think the other millions of investors will do.  It’s often tough to predict the behavior of 2-3 poker playing partners.  Predicting how millions of investors will place their bets is near impossible.

Most of the articles that have been peppering the news media speculating about the effects of default focus heavily on interest rates. Example: today’s NYTimes.  If you’re a banker, corporate treasurer, or hedge fund manager, that’s your biggest concern.  But there’s other more significant ways either default or any major spending cuts deal will affect everyday folks like you my readers.  There’s likely three ways either a default or a drastic cut in government spending (cut in deficit) will effect everyday folks.  So while we can’t predict exactly how things will play out, here’s a guide to where the possible dynamics are.  Here’s what we know:

  1. Interest Rates – Nobody knows for sure.  A majority of economists and bankers believe that a government default will raise interest rates on government bonds.  Accepted theories on interest rates then imply that all other interest rates would likely also go up a similar amount.  But this is far from certain.  Japan has had debt levels more than twice as high as the U.S. for well over decade.  Ratings agencies have down-graded Japanese debt.  But Japan still enjoys interest rates lower than the U.S.  I’ve read analyses by respectable economists and Wall Street types that pose plausible scenarios in which markets don’t raise interest rates at all, or that only government debt rates go up but private debt doesn’t.  I’ve even read scenarios wherein interest rates might slightly decline – although they are already so low there’s not much room to go lower.  Right now the markets aren’t showing any indication of higher rates. Anybody tells you they know what will happen to interest rates is telling you more than they know.  In fact, they’re telling more than what’s knowable now.
  2. Ratings on Government Debt – The bond ratings agencies, Moody’s, S&P, and Fitch, are threatening to downgrade US bonds from AAA to a lesser rating. Separate from any impact on interest rates, a downgrade might cause bond market turmoil and a lot of trading.  This would be because pension funds and other entities are often required by regulations and laws to keep a certain % of assets in AAA rated securities.  If US bonds are down-rated, then pension funds might have to sell their bonds and go into something else.  Nobody knows what that else might be or whether there’s enough of that something else to satisfy the demand.  As Krugman observed, when the bond ratings agencies speak, they have a lousy record.  They thought sub-prime mortgage securities were AAA because the banks said they were.  The agencies have been dead wrong about Japan.  Quoting Krugman: “when S&P or Moody’s speaks, that’s not the voice of “the market”. It’s just some guys with an agenda, and a very poor track record. And we have no idea how much effect their actions will have.”
  3. Government Spending Cuts & GDP. This one we know for sure.  If the government cuts it’s spending significantly at this time of high unemployment & low demand, it will slow the economy, depress GDP, and raise unemployment.    How much?  Here’s a quick rule-of-thumb, back-of-the-envelope calculation.  The GDP is now roughly $15 trillion.   Of that $15 trillion, $3.8 trillion comes from federal government spending.  $150 billion is 1% of GDP. So every $150 billion in spending cuts that the government does this year means a drop of 1% in GDP.  Right now, projections are that the government deficit in August alone will be close to $140 billion.  So, if the government has to suddenly cut it’s spending to match tax receipts (an instant balanced budget), it means the GDP shrinks by 1% every month.  In 2008-09, GDP only dropped by approximately 6% in total.  An instant balanced budget with no increase in borrowing will mean a recession more severe than 2008-09.  What will that do to unemployment?  According to estimates of Okun’s law, every 1% drop in GDP will bring a half percentage point increase in the unemployment rate.  So if we instantly balance the federal budget by cutting spending as many Tea Party members want, we will decrease GDP by 5% and unemployment will rise to around 11.5 – 12% by Christmas.
  4. Business Confidence.  Many Tea Party types and others are claiming that a balanced budget and no increase in the national debt will “restore business confidence” and unleash economic growth.  Hogwash.  Won’t happen.  Can’t happen. Hasn’t happened before.  This is the “growth from government austerity” pitch that has been made to Ireland in 2009.  Ireland did it and has only slowed further and had unemployment rise.  The Conservatives in the UK promised that budget cuts last year would stimulate the economy.  Hasn’t happened.  The UK economy slowed and is dead  in the water now.  In fact, we don’t have any recorded episodes of a major developed country stimulating it’s economy and reducing unemployment as a result. That’s because cutting spending is contractionary fiscal policy, which is, well, contractionary.  Government spending creates jobs and incomes just as much as private spending.  Right now, with high unemployment, we have too little aggregate spending in the economy.  Businesses are not spending because they fear the government’s budget.  They’re not spending because nobody’s buying – there’s no demand. Instead of wagering that government austerity will bring growth and employment, you’re better off betting on pigs flying.  The odds are better.

2 thoughts on “What Happens If Government Debt Ceiling Isn’t Raised? 2 Things That Might, 1 That Will, and 1 That Won’t

  1. Pingback: What Is Obama Waiting For? « EconProph

  2. Pingback: What Happens If Debt Ceiling Is or Isn’t Raised – How It Plays Out « EconProph

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