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.

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/

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.

More on What Happens If Debt Ceiling Isn’t Raised

I’ve mentioned in many previous posts that government debt is really not like private debt.  Instead government bonds are more like another type of currency or money.  The key difference between government bonds and paper money is that bonds pay interest and money doesn’t.  That’s about it.  But it’s a key point because government bonds, specifically T-Bills, are actually used like money.  Large corporations and pension funds don’t keep cash (paper money) lying around.  Instead these days they take whatever money they have each day and put it into liquid T-bills to earn just a little interest.

Spencer at Angry Bear offers more analysis on possible outcomes if Congress fails to raise the debt ceiling in a timely manner (emphasis is mine):

If the debt ceiling is not raised at some point the US government will be unable to meet all of its obligations.

I assume that they will make their interest payments and bond redemptions on schedule and the shortfall will be in paying social secutiry, medicare, military and other obligations. This will naturally impact aggregrate demand and generate a significant negative impact on the economy. Given the severe weakness in the economy this shock most likely would tilt the economy into a recession.

This is rather straight forward analysis, but the more severe situation would be the consequences of the government failing to redeem T bonds and/or T bills or failing to make an interest payment of these debt obligations.

Large business and financial institutions do not leave large sums sitting around not earning interest. For the most part firms invest idle balances in T bills. This reached the point long ago where banks introduced sweep accounts where they will go through a firms deposits late in the day and sweep their balance out and invest them in T bills overnight. This is where the risk free instrument comes to play a major role in the financial system and the economy. In many ways the risk free investment of T bills are like the oil in an engine. It provides the buffer or lubrication in the financial system that allow the various moving parts of the economy to move freely and not rub against each other. If the risk free instrument of the T bill is removed from the system there is nothing around of sufficient size to provide the lubrication that the system requires. Thus, if firms no longer have T bills or risk free instruments to invest in there is a danger that the financial system will seize up like an engine without oil. It becomes a question of confidence and we could quickly have a repeat of something like what happened in 2008 after Lehman Brothers went bankrupt and lenders pulled in their horns and refused to lend to otherwise good credits. This is why those claiming that the US defaulting on its debts would not have severe and wide-ranging consequences are completely wrong. It is why some of the largest financial institutions are already starting to take measures to protect themselves against this possibility.

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.