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.

GDP for 2nd Qtr: Economy In “Growth Recession” – Very Bad News

The Bureau of Economic Analysis released the “advance estimate” of 2nd Quarter 2011 GDP growth.  The numbers are bad.  Worse than most analysts expected.  I’ll let BEA explain:

Real gross domestic product -- the output of goods and services produced by labor and property
located in the United States -- increased at an annual rate of 1.3 percent in the second quarter of 2011,
(that is, from the first quarter to the second quarter), according to the "advance" estimate released by the
Bureau of Economic Analysis.  In the first quarter, real GDP increased 0.4 percent.

A 1.3 percent annualized growth rate is very bad.  Yes, it’s a positive number which indicates real growth and not decline, but it’s not enough to keep people even, let alone putting unemployed people back to work.  What’s worse, the BEA, as part of it’s annual revision process in July of year, revises the past numbers based on better data and better information than what was available at the time.  They revised their estimate of real GDP growth in first quarter 2011 down to 0.4% annualized rate from the previously estimated 1.8%.

Putting both quarters together it means the U.S. economy has grown at a 0.8% growth rate for the first six months of 2011.  As said earlier, yes, that’s a positive number so it indicates “growth”.  But that’s growth in the total or aggregate size of the economy.  During those same six months our population grew at a 1% annualized rate.  So do the math.  The pie is 0.8% bigger but there’s 1% more mouths at the table.  It means less per person.

I’ve mentioned before how economists have an inadequate vocabulary when it comes to describing the condition of the economy.  We tend to use only the terms “recession”, which means decline or negative growth, and “recovery” which technically means “not a recession” or any positive growth rate.  But not all positive growth rates have positive results.

There’s an unofficial term used in economics called a “growth recession”.  A growth recession is when real GDP is growing – the rate is above zero – but it’s too small to really make an improvement in living standards or improvement in employment.  That’s where we’re at now.  We’re in a “growth recession”.  Technically GDP is still growing, but it’s so slow and so weak that unemployment will actually rise.

Today’s news on GDP in first and second quarters has taken many most analysts by surprise.  But it really shouldn’t be a surprise.  The Obama “stimulus” spending program started in 2009, which was way too small to begin with, is being phased out. With it federal government spending in the first six months has actually declined.  The biggest culprit in the weak GDP numbers though is consumption spending by households.  It has come to a virtual standstill at the end of June.  Why?  Well, unemployment is rising again – no jobs, no money to spend.  Unemployment compensation has been cut in many states and many long-term unemployed have run out of benefits.  Again, that cuts spending.  And in Congress, Republicans with Obama’s help have been pushing a cut-spending, cut-deficits agenda.  In economics this is called “contractionary fiscal policy”.  And that’s what we’re getting – a contraction of GDP.  No surprise really.