Chicken Little Meets the Boy Who Cried Wolf: Some Thoughts on the Debt Ceiling Debate

Posted by Jeffrey Brown on Jul 25, 2011

Filed Under (U.S. Fiscal Policy)

If you’ve been following the news regarding the debt ceiling (and how could you not?), then you have probably been wondering who to believe.  Depending on who you listen to, a failure to raise the debt ceiling is either Chicken Little or the Boy Who Cried Wolf.

Phrases such as Armageddon, lights out and playing with fire are being used by Democrats (including, but not limited to, treasury secretary Geithner and President Obama) to convey a sense of urgency to the American people in an attempt to force the Republicans to raise the debt ceiling.  On the Republican side, the Tea Party wing of the party has made a credible threat to not raise the debt ceiling unless accompanied by substantial spending reductions (Here I should confess my error in a post earlier this year suggesting it was difficult to make the threat credible.  They have done so.)  Lately, I have heard some on the right begin to question whether a failure to raise the debt ceiling would really be all that bad.

Let me be clear – this is a dangerous game we are playing.  But it is dangerous on both sides.  Democrats are right that a failure to raise the debt ceiling could have a serious negative impact on an already-fragile and weak economic recovery.  Republicans are right that a failure to get our deficits and government spending under control could have even more serious consequences for our economy over the long-run. 

Should the deadline set by Secretary Geithner of August 2nd come with no deal reached, the government will not be able to do any additional net borrowing.  Thus, the United States be left in a position to ‘prioritize their payments.’  Indeed, President Obama created a political firestorm by suggesting that Social Security payments might be delayed.  This prompted Republicans to remind the President that we have a Social Security Trust Fund.  This struck me as the ultimate irony, given that Republicans (including me) have spent the past two decades in the Social Security debate trying to remind everyone why the Trust Funds are little more than an accounting device!  But I digress …    

So, what would happen?  If the debt ceiling is reached, the federal government will be placed in a position where they will have to choose whom to pay with the tax revenue coming available.  Interestingly, the Republicans have been quick to name things that should NOT be touched.  As one of many examples, Tim Pawlenty, a Republican presidential candidate, said “the outside creditors should be paid first, followed by the military.”  Others have suggested that we also take Social Security and Medicare off the table in the short-run.  But Social Security, Medicare, military and debt-servicing make up an enormous share of our cash outflows, so if we try to balance on the backs of everything else, the cuts would have to be that much more severe.

Regardless of what we choose to take the hit, the reaction from financial markets would likely be quite bad.  If the rating agencies downgrade U.S. government debt, the government’s borrowing rate will rise.  The value of bonds will fall, as will stock prices.  This negative wealth shock that would reduce consumption, a key driver of economic activity.  Consumer confidence would take a hit, reducing economic activity even further.  Interest rates on variable rate mortgages, car loans, student loans, and business loans would increase.  If government debt is downgraded enough, then financial institutions (such as insurance companies, banks, etc) might be subject to additional capital requirements (given that a large share of their assets are held in supposedly risk-free treasuries).  This could make even less money available for financial institutions to loan out or invest.  In short, higher interest rates and tighter credit can act like sand in the gears of the economy.  Remember Fall 2008?   

So, why would anyone in their right mind even threaten a default, let alone follow-through on it?  Because, sadly, we appear to need the threat of a really bad economic event to prevent us from precipitating another, even larger, bad economic event down the road.  In a sign of just how dysfunctional our government has become, it seems that Washington is unable to get its act together and address our very serious long-term fiscal problems.  It is not out of a lack of understanding – it is, after all, common knowledge in Washington that deficits are out of control.  It is a lack of political will, political courage, and leadership.

So, some are betting that the threat of default is what we need to get people serious about long-term deficit reduction.  And they have certainly succeeded in getting deficit reduction on the political agenda with an urgency that we have not seen in many years.  If they succeed in avoiding default by getting bipartisan agreement to substantial deficit reduction, this may go down as one of the most brilliant political and economic moves of our lifetime.  But if the gridlock continues and the two sides are unable to reach an agreement, we could be left with a large negative financial market shock, accompanied by the even greater realization that our government is incapable of getting its fiscal house in order.  A really bad outcome for an economy already struggling to revive. 

Many months ago, I saw Alan Greenspan on a Sunday morning talk show.  When asked if we would ever solve our fiscal problems, he said, “yes.”  Then after a short pause, he said something along the lines of: “the question is whether we will do so before or after a bond market crisis.”

Let’s hope it is before next week.