We Have A Debt-Ceiling Deal. The Economy Loses.

Earlier this week the absurd and totally unnecessary debate in Washington over raising the national debt-ceiling came to an agreement, both houses of Congress passed it, and the President signed it.  Earlier this week I gave this metaphor for the deal, wondering why we need enemies with “friends” like our representatives in Washington.  Now that I’ve had a little more time to reflect, read some more on the details, comment on radio & TV about it, I think I was too easy on it.  It’s worse than it first appears.

This deal doesn’t “guarantee” that the U.S. government will reduce it’s deficit and maintain “solvency” (a non-concept for a sovereign country with a central bank).  Instead, this deal is more likely to guarantee that our economic non-recovery does, indeed, become at least a lost decade, if not a depression.  Right now I want to look at the economic impact of the deal.  In another post I’ll look at another casualty of the deal and the probably political-economy impact.

So what does the deal do specifically?  Well the details are fairly complex, even by Washington standards.  Right now the debt ceiling rises by $400 billion – enough to last for probably 3-4 months.  No real cuts will happen for maybe 60 more days.  Then starting in October 2011, which is the start of the government’s fiscal year 2012 budget (see here for definition of fiscal year), the action begins. Caps on spending start.  There are no tax or revenue changes in the deal.  It starts modestly with only $21 billion in spending cuts in 2012, although many of those cuts will be felt painfully by many citizens.  Students in graduate school in particular will feel the pinch in their pocket. Then in the remaining 9 years of the deal, there will be at least another $896 billion in reduced spending, amounting to about $100 billion less spending per year than currently planned.

This total of $917 billion in reduced spending is only the start though.  Congress is going to appoint a “special joint committee” of 12 members to recommend and additional $1.2-1.5 trillion in either spending cuts or tax revenue increases over the next 10 years.  (if you believe that committee with half Republicans will allow any revenue increases, I have a bridge in Brooklyn for sale).  If Congress doesn’t adopt those cuts, then Medicare payments, defense spending, and other discretionary spending would automatically by cut across the board. Either way spending gets cut another $1.2 trillion for the years 2013-2022.

This deal is supposed to raise the debt ceiling enough to get us through the end  of 2012 and the presidential election before the debt ceiling has to be raised again, sparing us this debate.  Don’t bet the your house on that though because House Republicans are betting they can keep this debate alive through then.  Basically Congress has created an elaborate mechanism in this law that increases the debt ceiling in several steps between now and the end of 2012.  But the way it’s done is that the debt ceiling keeps going up unless Congress votes to stop it (which the President would then veto).  It’s  a way for Republicans to keep talking about the debt and deficit, to keep recording “votes” against it, but all the time knowing that the debt ceiling will rise because it has to.  Pure politics at the expense of the country.

Right now the economy has over 9% unemployment.  Inflation is so low that deflation is actually the threat. The economy has effectively stalled or at least reached “stall speed”, threatening another double-dip recession.  This is not the time to be cutting spending.  To the degree spending cuts are necessary, they should happen when the economy is at or nearing full employment, not now.  At this time the economy needs all the spending it can find whether it’s from consumers, firms, or government.  And right now, firms and consumers are pulling back and keeping their wallets closed.  The government needs to step up and fill the gap.

So bottom-line, what should we expect?  I’ve seen several estimates from folks with more sophisticated econometric models than I can access.  My own back-of-the-envelope calculations and intuition say the drag on the economy is significant.  In 2012, this deal is probably going to take up to another 0.4 percentage points off of GDP growth.  The real damage starts in 2013 with a reduction closer to 1%.  Remember we’ve only grown at 0.8% rate so far in the first half of 2011, so 2012 will be close to zero growth and 2013 will likely be negative unless some other source of growth and spending can be found.  Looking around, it’s hard to imagine where that could be.  Instead I see nothing but possible negative risks: Europe imploding in a currency and austerity crisis, China having to pull back to slow their inflation, the housing mess in the U.S. is still bad, U.S. banks aren’t as healthy as they claim.

The estimates I’ve seen are similar.  Economic Policy Institute says the debt ceiling deal with cost us 1.8 million jobs in 2012 alone. The same article reports:

Top economists and CEO’s have also weighed in against the deal and said that GOP concessions to the Tea Party will cost our economy dearly. Pimco CEO Mohamed El-Erian warned that the deal will lead to less growth, more unemployment, and more inequality. Nobel Prize-winning economist Paul Krugman called the plan “a disaster” and “an abject surrender” that will “depress the economy even further.”

The Center for American Progress’s Michael Ettlinger and Michael Linden argue that while the deal “goes straight in the wrong direction,” Congress can redeem itself by using the so-called “super committee” mandated by the bill to focus on job creation. The committee, made up of six Republicans and six Democrats, is tasked with finding an additional $1.5 trillion of deficit reduction over the next 10 years, and must report a plan by Thanksgiving.

It’s noteworthy that J.P.Morgan Chase Bank’s research department, as representative of Wall Street as any, says that overall with this deal, government budget policy in 2012 subtract at least 1.5% points from GDP growth rate in 2012.  Since  it takes at least 2% growth in GDP to keep unemployment stable and we haven’t even had a single quarter of growth at more than a 4% rate since the end of 2006, things look grim for employment.

The cutters and austerians have won.  They will make a wasteland of the economy in the name of fighting the deficit.

There Is An Efffective Way to Reduce Government Deficit: Employment. But They Won’t Take That Route.

In the whole crazy, unnecessary debate over raising the debt-ceiling law, politicians, reporters, and commentators all spoke as if there were only two ways to reduce the government deficits.  Nearly everyone took it as an article of “serious thinking” that to reduce a deficit requires either reducing spending or increasing taxes.  But rather than being evidence of “serious thinking”, such talk is evidence of sloppy, imprecise, and ignorant thinking.  Such talk totally ignores the role of economic growth in determining government budgets and it ignores the role of the government in the economy.  It’s evidence of the government-as-household fallacy, the idea that government is just like a big household and subject to the same constraints as you and I.

There is a way to balance the budget that doesn’t require cutting major spending programs.  And it doesn’t require big tax increases.  It’s called economic growth and putting people back to work.  The major cause of the deficit is because we have very high unemployment.  We have over 9% reported unemployment.  That number rises to approximately 16% if we count all the people working part-time jobs but that desperately want full-time work and more hours.  And finally, both numbers totally ignore the fact that since we fell into this depression in 2007 well over 5% of adult Americans have chosen to drop out of the labor force altogether for now.  If we put those people back to work, they pay taxes. Government revenues will increase even without a tax rate increase.  If we put those people back to work, then government spending on unemployment compensation, Medicaid, welfare, and a host of other safety net programs goes down.  Automatically. Without cutting any programs or harming anyone.

This idea that economic growth and full employment will reduce deficits isn’t some theoretical possibility that only exists in the models of some economists.  We’ve done it before.  Other countries have done it.  In fact, everytime the U.S. has reduced it’s deficit it’s been by increasing employment.  The route to a small deficit or even a balanced budget lies in achieving full employment first, not in contrived artificial balanced budget amendments.

It wasn’t until the debt-ceiling debate was practically finished (for now – it will be back like zombie or vampire) that any in the media took notice that growth and employment is the key.  Last Sunday, July 31, as the President and the Republican Speaker announced their deal to cut spending and raise the debt ceiling, the New York Times finally runs a decent article about how growth is the real answer (bold emphases are mine):

 We wouldn’t need any of that [reduce spending, raise taxes, inflation, or default] if we could restore economic growth. If that happened, Americans would become richer and pay more taxes. Et voilà! — we’d pay down the debt painlessly.

Crazy as that might sound, particularly given Friday’s figures, the possibility isn’t some economic equivalent of that nice big farm where your childhood dog Skip was sent to run free. There are precedents.

Before its economy crashed, Ireland was a star of this sort of debt reduction. In the 1980s, Ireland’s debt dwarfed its economy. Over the next two decades, though, that debt shrank to about a quarter of gross domestic product, largely because the economy went gangbusters.

“Ireland went from being, you know, the emerging market in a European context, to a very dynamic economy,” says Carmen Reinhart, a senior fellow at the Peterson Institute for International Economics and co-author of “This Time Is Different,” a history of debt crises.

The United States has done the same in the past, too. After World War II, gross federal debt reached 122 percent of G.D.P., the highest ratio on record. But over the next 40 years, it fell to about 33 percent. That wasn’t because some blue-ribbon panel prescribed austerity; it was because the American economy became much, much richer.

The same happened during the prosperous 1990s, which began with deficits and ended with surpluses. Former President Bill Clinton is often credited for that turnabout, as he engineered higher tax rates. But most economists attribute the surplus years primarily to extraordinarily rapid growth.

It would be lovely to repeat that experience today, and send our federal debt off to that farm with Skip…

Usually after a recession, growth snaps back quickly and the economy makes up for ground lost — and then some. That’s not the case this time, at least so far. In the 60 years before the Great Recession, the economy expanded at an average annual rate of 3.5 percent. In the second quarter of this year, it grew at less than half of that pace, putting us further and further behind where we would be if the economy were functioning normally.

Unfortunately the article still tries to give the reader the impression that growth/full employment is difficult or unlikely this time.  It tries to give the impression that the growth during the Clinton years was somehow extraordinarily fast.  It was only fast by comparison with either the Bush I, Bush II or the first Reagan terms.  In fact, the growth during the Clinton years was only average at best when compared to what was achieved routinely during 1950-1973 or even during the Carter years.  The article also falsely claims that our “aging population” will require unusually large demands on government resources.  In fact the demands of the aging baby boomers on either Social Security or Medicare aren’t any greater than the resources we devoted to educating those baby boomers in the 1950′s and 1960′s.

Nonetheless, the point of the article is right on:  growth and growth in employment is the way to go if you’re worried about the deficit & debt (which I’m not, but that’s another issue).  The deficit we have is a jobs deficit, not a fiscal or budget deficit.  That’s what we need to worry about.

Washington and the chattering political classes have it wrong.  Their “serious” talk is anything but.

So We Have a Debt-Ceiling Deal. Whoppee. With “Friends” Like These…

Ok, we have a “deal” in Washington to raise the debt ceiling.  Big whoop.  With friends like these, we don’t need enemies.  I don’t much time today (end of semester, grading, and all), but I’ll comment tomorrow in more depth.

Meanwhile, I’ll leave you with this metaphor for how I see the debt-ceiling deal and it’s spending cuts, new “super-congressional” committees, etc.   Picture the economy as a person crossing the street.  The person is frail, sickly from an infection, and has a broken leg in a cast.  That’s because the economy hasn’t healed from 3 years ago when it got hit by speeding truck called The Great Financial Crisis.   Just as the person is in the middle of the street, we see two cars driven by reckless youngsters drag racing down the street – a totally unnecessary activity.  Both drivers saw the person several blocks away but they kept speeding straight toward the person, yelling at each other that the other one should swerve or stop to avoid hitting the poor hobbled pedestrian.  Now at the very last minute, a shred of sanity prevailed and the two cars keep speeding, but they swerved just enough to miss hitting the economy.  But in the process of swerving, they’ve knocked our economy/pedestrian down to the ground.

The good news is we avoided being run over and possibly killed.  The bad news is that not only are we still sick, infected, and have a broken leg, we might also have more bruises and injuries from the close-call.

Students Have A Stake in The Debt-Ceiling Crisis

Any higher education students out there who think the whole Washington debate about raising the debt ceiling is just some hypothetical exercise that doesn’t affect you, think again.  If the debt ceiling isn’t raised, then we don’t know what the government will pay and what it won’t pay in August and September.  And Treasury isn’t dropping any clues as to what they’ll pay and what they won’t.  Your student financial aid, your  Pell grant or tuition grant or research grant, might be what doesn’t get paid.  Just because it’s approved now, doesn’t mean the government will actually pay it without a debt ceiling increase.

See:  http://money.cnn.com/2011/07/29/news/economy/debt_default_student_financial_aid/

But What About National Debt-to-GDP Ratio? Not a Problem, Really

In the comments to my post on the extraordinarily weak 2nd qtr 2011 GDP numbers a reader asks for my thoughts about debt-to-GDP ratio and “how can we afford more stimulus”?  Since my response will be a little long and others might be interested, I’ll post it here.

Reader AZLeader asks:

Here are some other GDP indicators I’d value your comments on…

Government spending now is somewhere around 28% of GDP, well above the 60 year average of 18.6% or so.

Spending as a % of GDP is indeed up, but it’s not primarily as a result of discretionary spending going up.  In other words, the so-called Stimulus spending bill didn’t do the damage.  The ratio is up in large part because the denominator (GDP) shrunk.  We lost a huge chunk of GDP.  That has a double effect on the ratio.  When the economy goes into recession and doesn’t recover it reduces the denominator by a big chunk.  But a recession also automatically increases government spending through automatic stabilizers.  Spending on unemployment compensation, welfare, Medicaid, SS disability claims, etc. automatically increases, thus increasing the numerator as well.

Krugman shows this graph from the St.Louis Fed using non-partisan Congressional Budget Office data that compares the changes in spending to changes in the potential GDP over 60+ years.  Potential GDP is the GDP that would be produced if we were at full employment.  It indicates our capacity to produce if we choose to put all our resources (labor) to work.  Any value that’s above 1.0 indicates that spending is rising faster than potential GDP. A value less than 1.0 indicates that spending is might be increasing in total dollars, but it’s increasing less than what the potential GDP is.  When the value is less than 1.0 it means that government spending is having a contractionary effect on the economy. As you can see, the issue in the last few years is that despite the increase in dollars of spending, it’s been peanuts compared to the damage done by the banks’ financial crisis and the ensuing recession with high unemployment.  This part of the reason why I’ve (and a lot  of others) have said the stimulus program was too little and too short.

Government deficit spending last year was about 10.9% of GDP, way over the sustainable comfort level of 2.6%.

There’s two issues here.  First, There’s nothing that says 2.6% deficit as % of actual GDP is “sustainable” and greater than that isn’t.  “Sustainable” in the sense that we can operate at that level indefinitely might be less than 2.6% or it might be greater than 2.6%.  For private sector entities (you,me, households, corporations, state governments) there’s a real meaning to “sustainable”.  But that’s because ultimately our spending ability is limited by the combination of our earning and borrowing ability.  Borrow too much and eventually lenders say “I don’t think you can pay it back, so pay higher interest rates, the debt begins to spiral up, etc.”.  But for a sovereign national government that creates it’s own currency, borrows using bonds denominated in that currency, and doesn’t strap itself to some fixed exchange rate system (like gold standard), there is no financial limit to the borrowing.  All of the nations that are having debt crises now (or in the past) have either strapped themselves to somebody else’s currency (Greece & Ireland with the Euro, Argentina in 2000 with the dollar) OR they borrowed their money in somebody else’s currency (less developed countries borrow in $ not their own currencies) OR they have  a fixed exchange rate (under the old gold standard 80 years ago).

What matters for “sustainability” is the ability of the economy to produce.  Does it have the  real resources to produce what the government is willing to spend on?  In this sense we see that even a 1-2% deficit-to-GDP ratio might be too high if we were at full employment and had no excess resources.  But the U.S. today has more than 10% of it’s labor force (even more since many would be workers aren’t looking) sitting on it’s hands doing nothing.

Another way of looking at the sustainability and desirability of deficit spending is to compare the interest rate the government has to pay to borrow now vs. the long-term growth rate of the economy.  If interest rates on government bonds were in the 6-8% range or higher (like in Greece and Italy), then large deficit spending might not be sustainable. But the U.S. is borrowing at near record low interest rates, less than 1% for a year.   Borrow at low rates, spend to invest in those things that grow your economy and get paid back later in larger GDP.

That brings me to my second point on “sustainability”.  The budget, government spending, is dynamic.  What GDP is the greatest determinant of what the deficit actually ends up being.  The budget discussions in Washington about 10 year projections are usually static projections.  They assume they can change the spending amounts while keeping the projected path of GDP the same.  Doesn’t work that way.  Running a large deficit relative to GDP, the kind of stimulus I think we need, will raise the deficit-to-GDP number immediately, but the ratio will then automatically decline. Again it’s the automatic stabilizers mentioned earlier.  As people go back to work and unemployment declines, the GDP rises faster.  Those people also pay taxes, so government revenues increase.  Spending in the form of unemployment comp, welfare, disability payments, Medicaid, etc all drop as people go back to work.  The deficit automatically shrinks relative to GDP.  This was how Clinton managed to produce a narrow government surplus at the end of this second term.  He eliminated the deficit completely.  It wasn’t by cutting spending. It was because the economy grew enough to reach full employment.

Government debt is just under 100% of GDP, the highest level in our economy that we’ve seen since WWII where it briefly spiked well above that.

Yeah, so what? Japan’s debt is around 200% of GDP and has been for over a decade.  Government debt is not like private debt.  It doesn’t have to be paid off. Government bonds are really just like government issued paper currency that pays interest.  This is why banks and investors love government bonds.  It’s a way to hold large amounts of cash and still earn interest.  A growing economy also needs a growing money supply and a growing supply of government bonds.  In the early part of this past decade (I forget the year), Australia was running a surplus for a few years.  It was paying down it’s national debt.  The bankers went to the Australian Treasury and the Australian central bank and asked the government to borrow and issue bonds anyway because they needed a larger volume of bonds in existence in order to run the banks.

Through “Intergovernmental Holdings” the U.S. government owns about 1/3rd of its own debt.

Yes.  $4.6 trillion, approximately 1/3,  of the $14.3 trillion total US government debt is “owned” by various other parts of the government.  The biggest chunk is the Social Security trust fund, $2.7 trillion.  The rest is in various other government “trust funds” such as Railroad employees retirement fund, government employees pension plans, highway building trust fund (paid by gas taxes), etc.  These funds reflect special taxes or fees that have been collected that are by law dedicated to a particular purpose, but the government hasn’t spent the money on that purpose  yet.  The accumulation of money in these funds (think of them as pre-payments of special taxes) must by law then be “invested” in the safest interest bearing assets available, which happen to be U.S. government bonds.  Let’s take a brief look at one of these funds: the Social Security trust fund.  The way SS works, dedicated SS payroll taxes are collected each month to pay for this month’s benefits.  (FICA taxes).  Obviously we want benefits to be relatively constant month-by-month.  Grandma wants to know just how much her check will be next month.  But the payroll taxes collected each month vary greatly. So, by the original law, SS Admin was supposed to make sure it always had enough liquid cash on hand to pay 1 year’s anticipated benefits.  This is the trust fund.  In the 1980′s the trust fund was too low – nearly depleted because benefits had been increased.  So payroll taxes were increased.  When the trust fund had fully recovered (circa 1991), the decision was made to continue to collect extra payroll taxes from workers in the 1990′s and early 2000′s in anticipation of the baby boom.  The current $2.7 trillion trust fund represents way more than the law said was necessary.  It represents the baby boomers having already pre-paid their own retirements.

These intra-governmental bonds cannot be traded on the public market, but they are regular debt obligations of the Treasury nonetheless.  To not pay these bonds is to renege on previous promises that people have relied upon.  It also might not be legal, although that is outside my experise.

In addition to the $4.3 intragovernmental holdings, there’s $1.6 trillion in government bonds held by The Federal Reserve.  These are ordinary bonds that The Fed bought from banks (that’s where banks get reserves).  Any interest paid on these bonds goes to The Fed who then sends it back to the Treasury as Fed profits.  This amount could easily be reduced by maybe 1/2 without consequences.

Given these constraints, where can we get the money to fund spending programs like the “stimulus” to create jobs and recover the economy?

As I attempted to describe above, it’s a fallacy to think of the government as having a financial constraint on it’s resources.  Government (again, a sovereign, fiat money, floating exchange rate, government that borrows in it’s own currency) faces no financial constraint.  Government is not like a household no matter how often misguided politicians say it.  You, I, households, firms, corporations, and state and local governments must obtain cash from either income or borrowing before we spend it.  Government does not face that constraint.  Government defines and creates the reserves that can become our spending money.  It has a monopoly on the creation of money.  And money today can be created as fast a somebody at the central bank can type (although we may not want to create it that fast).

Let’s consider what actually happens when the government spends.  The Treasury writes a check and sends it to a contractor, or SS beneficiary, or someone.  That check is drawn on an account at The Fed Reserve bank.  Let’s suppose you get the check.  You got income from the government. You take the check to your bank, let’s say it’s Chase.  You deposit it in your checking account.  You go out and spend the money by using your debit card to buy dinner, thereby helping to create a job and employ a waiter and kitchen staff.  But what happens at the bank?  Chase takes your check and sends it to The Federal Reserve. The Federal Reserve takes the government check and credits Chase’s account at The Fed.  This creates bank reserves.  The Federal Reserve has no limit on how much bank reserves they can create.  They can create all they want.  In the barbarous old days of the gold standard (before 1971), The Fed would have had to make sure it had enough gold on hand before issuing any reserves.  No such limit now.

So why doesn’t the government just spend endlessly with no limit?  Well, there’s no financial constraint on the government spending, but there’s a real resource constraint.  When the government attempts to increase deficit spending it is in effect placing orders for work to be done, things to be produced, and people to be employed (you do the same thing when you spend).  As long as there are unemployed resources to be put to work, the deficit spending is OK.  It stimulates more activity.  But if there are no idle resources then increased deficit spending will produce inflation because the government would be bidding against everybody else for resources.  At nearly 10% unemployment we have plenty of idle resources and that’s why there’s no threat of inflation despite the worries of those who don’t understand the gold standard ended 40 years ago.

There’s one other aspect of deficit spending that’s important.  This is not the result of theory, but rather is pure accounting.  I’ll just give a very brief mention of it here, but there’s a full tutorial here by Randall Wray.  A one page view of this idea is here.  Basically, government deficits are the mirror of the private sector.  There’s three “balances” that must add up to zero.  There’s the government spending vs. taxes balance, called the budget deficit.  There’s the question of whether the private sector (all households and firms together) are accumulating financial assets.  This is called “net private financial wealth”.  It’s the difference between what our private incomes each year and our private spending.  If we spend less than our income, then we are accumulating net financial assets, or in plain language, we’re putting money away in our bank accounts and investment accounts.  There’s a third balance which is the external capital account balance.  Basically it’s like the private net financial asset accumulation except it records how much foreigners are accumulating U.S. denominated financial assets.  If imports are greater than exports (trade deficit), then foreigners are collecting U.S. financial assets, typically government bonds.

Now there’s no way the private sector can create net any new financial assets. If I loan money to you, yes, I create a financial asset on my books.  But you’ve created an exactly offsetting private debt on your books.  In aggregate, the private sector cannot create new financial assets.  That’s because financial assets are things like money, currency, and bonds.  And they can only be  created by government. They can also be gotten from foreigners by selling more exports than imports, but that ain’t gonna happen anytime soon.  By accounting, these three balances must equal zero.  This means that when the government runs a deficit it creates net financial assets that the private sector can accumulate.  If the government creates a surplus.

In simple language, this means that, assuming we run a trade deficit, that a government deficit means the private sector can accumulate financial assets.  If the government runs a surplus, though, it means the private sector must go deeper into debt itself.  See the answer to question 1 here for another explanation. There’s a dramatic historical graph that beautifully illustrates this relationship over the last 60 years.  Unfortunately, I can’t put my hands (mouse, really) on it right now.  When I find it again I’ll update.  The point is that government surpluses, the kind that the Tea Party and many Republicans claim they want as being responsible, can only happen if the private sector as a whole goes deeper into debt.  It’s private debt that got us into the Great Recession/Financial Crisis, not public debt.  In fact, the Clinton surpluses were a small part of it because to create those Clinton surpluses the private sector had to go deeper into private debt – which we did. It was called mortgages, corporate debt, credit cards, student loans, etc.

A long response, but I hope it was worth it and helps.

What Happens If Debt Ceiling Is or Isn’t Raised – How It Plays Out (updated)

Yesterday I took a stab at describing what the consequences of a government default might be and I added to it here.  There’s basically three lessons to take away from those questions. One, nobody knows now exactly what happens, especially in financial markets.  Two, it all depends on the specifics of a deal or no deal to raise the debt ceiling.  Truth is that many of the proposed “deals” to raise the debt ceiling will have negative consequences for the economy as bad as if we don’t raise the ceiling.  And three, regardless of the specifics in financial markets, it will have very negative consequences on GDP and the real economy where most of us live and work.  What I want to address now is less of what the disaster will be as the how the economic side of crisis will likely unfold.

Reporters and politicians are using the metaphor or image of the economy moving toward a cliff to describe how things will happen economically.  They, and the President is one of them, are conjuring up an image whereby the economy is moving along just fine and dandy and then, if we don’t raise the debt ceiling, we will just fall off a cliff into a giant abyss on Aug. 2.  They’re acting as if there’s this hard-and-fast, unalterable deadline when the machine just stops.  If Congress passes a debt ceiling increase before Aug. 2 then they act like everything will be OK.  The image that comes to my mind is one of Coyote from the old Loony Tunes cartoons racing along a plateau towards a giant cliff.  At his current rate he’ll reach the edge on Aug 2.  If Congress votes an increase before Aug 2, then a bridge will appear out of nowhere and he goes on safely.  If they don’t Coyote just falls into the abyss.  That’s wrong and it’s misleading.

The better metaphor is not of a someone racing toward a cliff. The better metaphor is to imagine thousands of people all standing around at the edge of a cliff looking over the edge. The key is the cliff isn’t made of rock.  It’s made of ordinary sand and dirt and it’s weak.  And the cliff has a bit of an overhand to it.  Nobody can see clearly over the edge.  What will happen is that gradually people will get nervous.  Some folks decide to move back from the  edge – banks, investors, and funds decide to move their money out of US T-bills. But the movement starts to weaken and shake the ground.  Some dirt can be seen sliding over the edge.  More people begin to pull back.  The earth shakes and slips more.  It turns into a mob rush to start getting away from the cliff’s edge. But it’s too late.  The ground starts sliding slowly but it gains momentum.  It turns into a landslide.  The whole cliff slides down in a massive landslide taking huge numbers of people with it.  That’s how I see it.

We’re already seeing the beginning of the movements this week.  We have reports from the New York Times that Debt Ceiling Impasse Rattles Short-Term Credit Markets.  The stock markets aren’t in full panic mode. There’s been no 3-5% decline days of panic selling like we saw in 2008. Yet.  But we’ve seen the market turn decidedly down. It’s been losing about .8% per day all week for a 4% loss on the week.  Interest rates on short-term government T-bills are up a little, indicating that a growing desire to sell by many and get out.  (interestingly, the rate on long-term bonds are actually down a bit – funds appear to still be bullish on the U.S. long-term).  Right now there’s no panic. But as JP Morgan Chase CEO Jamie Dimon said today “We’re praying. And we’re planning”.

How bad could it get?  Again I’ll turn to Jamie Dimon:

Now, here’s what really would happen.

Every single company with treasuries, every insurance fund, every — every requirement that — it will start snowballing. Automatic, you don’t pay your debt, there will be default by ratings agencies. All short-term financing will disappear. I would have hundreds of work streams working around the world protecting our company for that kind of event.

Read more: http://www.businessinsider.com/jamie-dimon-debt-ceiling-isnt-raised-and-the-us-defaults-praying-2011-4#ixzz1TX9b0ypB

Even the Aug 2 deadline itself isn’t as hard and fast as the President and Secretary of the Treasury have made it out to be.  The original projected date when new government borrowing would have to stop was in mid-May.  But when that date came, the Treasury began to implement some extraordinary measures.  Instead of making cash payments to some government employee pension funds he gave them IOU’s – promises to make it good soon.  Cash payments to many government vendors have been slowed down.  They implemented tricks that are the big government equivalent of searching the sofa for loose change, or borrowing from the kids’ piggy banks, or using the full 15-day grace period to make the mortgage payment.  At the same time, cash tax collections have a just a tick better than projected.  Eventually these tricks run out.  Right now the latest estimates I’ve seen say the real cash-drop dead date is closer to Aug 10. But it’s likely the Treasury will stop something on Aug 2.  We just don’t know what.

My point here is that it’s not like Tuesday August 2 is calamity day and everything happens then.  It might. But things might fall apart before then.  Or they might fall apart a few days later.  Or things might continue to gradually get worse but without us realizing how bad it’s getting because we’re waiting for the dramatic fall off a cliff.  By the time we realize in mid-August that it’s a real disaster, we’ll be buried in the landslide.

This is crazy.  It’s no way to run a government or an economy, but it’s clear that the Republicans and Tea Party types would rather crash the economy than compromise. Unfortunately Obama is willing to help them do it.

UPDATE:  Some indicators of possible trouble could show up next Monday when the Treasury holds a “routine” auction of T-bills for refunding purposes.  Refunding doesn’t add net debt, it only rolls-over existing maturing debt.  Treasury will also announce it’s plans for future auctions at that time.  According to the Wall Street Journal Marketwatch:

A refunding is a replacement of government debt, often debt that is about to mature, with new debt. Officials typically meet with about half of the primary dealers each quarter to discuss the refunding.

On Monday, Treasury plans to release estimates of future borrowing. Two days later, it will release its refunding decisions, including how much in Treasury securities will be sold.

What Is Obama Waiting For?

I’m with Brad Delong and a host of others in wondering just why President Obama doesn’t simply do away with this whole silly, unnecessary debate about the debt ceiling.  Too much is at risk to continue this charade and silly theatrics.  Brad summarizes for us:

Does anybody have any doubt that any Republican President–Bush II or Bush I or Reagan or Ford or Nixon or Eisenhower or Hoover or Coolidge or Harding or Taft of Roosevelt–in Obama’s current situation would not hesitate but would use one of the many, many technical fixes to the debt ceiling problem, just as Clinton used a technical fix when he faced the same problem in 1995-1996?

No.

What Obama is thinking remains incomprehensible: a riddle inside a mystery inside of an enigma. But Michael Tomasky attempts to read the tea leaves:

President Obama Should But Won’t Raise the Debt Ceiling Unilaterally: Barack Obama surely has to be thinking hard about invoking Section 4 of the 14th Amendment, unilaterally raising the debt ceiling, and getting on with it. With the House Republicans now rejecting a proposal (Harry Reid’s) that is 100 percent cuts and no revenues, there can be little question in the minds of most non-Kool-Aid-swilling Americans about the identity of the unreasonable party. Indeed it could be argued that acting unilaterally now is the only responsible move. Bill Clinton… would pursue this course. And yet one senses the president is highly reluctant to do it. Why?

Three explanations strike me as plausible….

The first reason would be the straightforward and obvious one that he and his handlers fear the political repercussions. Some Republicans, and certainly the right-wing noise machine, will crow for impeachment. Obama and his White House are not exactly a group that itches for a fight. They would be dragged perforce into a partisan mud-wrestling match, which Obama has proved time and again he doesn’t want. And there are some legitimate legal questions surrounding the use of the 14th Amendment…. But in fact, this would in many ways be a gift to Obama. Calls for impeachment would likely perform the nifty trick of getting both left and center on his side….

The second reason Obama… really believes—still!—in civic-republican notions of government as an arena for reasoned deliberation. That he could still think this is akin to a child believing in Santa Claus until he’s 15—but apparently he does…. From this perspective a unilateral action would be almost impious…. Obama’s position has declined from admirable principle to indefensible fetish. Politics simply isn’t going to get better and more deliberative any time soon.

The third reason… is… Unilateral action would be at odds with Obama’s image of himself…. But Obama badly overestimated his abilities here. The contemporary American right ain’t the Harvard Law Review, where he was once able to get conservatives and critical race theorists to sit in the same room and reason together. Does he still really believe he can do this with today’s Republican Party? He apparently does. It’s hard to figure out why else he would have used Monday night’s speech to continue to argue for a “balanced” approach that was already off the table. He really must have thought Republicans would be inundated by constituent phone calls, come to their senses, and realize that, by golly, they’d better sit down and reason with Mr. Reasonable. If Obama thinks that, then he is caught up in mere egoism, and he is paradoxically harming the republic he believes he is….

[I]f Obama moved forcefully and said. “I am the president, and I met them here and here and here, and they wouldn’t budge, and I’m finished with them, and now is the time to act,” I have little doubt that the markets—and the people—would react positively. That would prove that he’s a leader, and it would force him to choose sides. It’s high time he did both.

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.