The Debt Ceiling Fiasco
Fights over the budget are normal and proper in a democracy. But threatening to default could have dire consequences for the dollar, interest rates and the economy.
By ALAN S. BLINDER
The debt ceiling "crisis" started on Monday when the U.S. government reached the legal limit on how much it is allowed to borrow—a limit that, curiously, counts even debts that one branch of government owes to another. But don't worry—yet. Treasury Secretary Tim Geithner has a variety of ways to push back the day of reckoning to early August. What happens then?
Before attempting an answer, let's first note that this should not be happening in the first place. Other countries pass budgets estimating total receipts and expenditures for the year, which in turn imply how much they plan to borrow. But not here. Our Congress can pass a budget that implies an illegal amount of new borrowing. In fact, it did so last month when the two parties agreed to a fiscal year 2011 budget projected to push the national debt over $15 trillion, even though the law limits the debt to $14.3 trillion.
What happens if we crash into the debt ceiling? Nobody really knows, but it's not likely to be pretty. Inflows and outflows of cash to and from the Treasury jump around from day to day as bills are paid and revenues arrive. But at average fiscal 2011 rates, receipts cover only about 60% of expenditures. So if we hit the borrowing wall traveling at full speed, the U.S. government's total outlays—a complex amalgam that includes everything from Social Security benefits to soldiers' pay to interest on the national debt—will have to drop by about 40% immediately.
How in the world do you do that? No one really knows. If and when the time comes, Mr. Geithner and his boss will have to decide. But here's one prediction: Defaulting on the national debt will not be their first choice. After all, the statue of Alexander Hamilton at the Treasury entrance reminds Mr. Geithner every day of the importance of maintaining the nation's creditworthiness. Even if we hit the debt ceiling, maturing obligations still can be rolled over. And I'll bet he will bend every effort to make the interest payments, too. Unfortunately, however, when you're 40% short, not much can be ruled out.
For a while, the Treasury can temporize with creative accounting, shifting money from one pile to another, and the like. For example, contributions to government employees' pension funds can be delayed. But a 40% shortfall translates to over $4 billion a day, including Saturdays and Sundays. At that rate, you run through your bag of tricks pretty fast and must find ways to conserve serious amounts of cash.
The bills for Social Security, Medicare, Medicaid, national defense and interest on the debt comprise about two-thirds of all federal outlays. So they can't all be sacrosanct indefinitely. At some point, Mr. Geithner could wind up brooding over horrible questions like these: Do we stop issuing checks for Social Security benefits, or for soldiers' pay, or for interest payments to the Chinese government? Such agonizing choices are what make default imaginable.
Imaginable, but unlikely. Should it occur, the consequences could be severe. It might, for example, reignite the world financial crisis. Remember how rattled financial markets became last year when it looked like Greece might default? And that was just little Greece and the possibility of default. An actual default by the mightiest nation on Earth would be immeasurably more unsettling. Where, in such a case, would frightened investors run to hide?
The U.S. dollar would be among the first casualties. If hot money were to flee what was once its safest haven, the dollar would sink and U.S. interest rates would rise. The latter could lead us back into recession.
There would also be lasting costs to the U.S. government in the form of higher interest rates. For as long as anyone can remember, the full faith and credit of the United States has been as good as gold—no one has better credit. But if investors start to see default as part of U.S. political gamesmanship, they will demand compensation for this novel risk. How much? Again, no one can know. But even if it's as little as 10-20 basis points on the U.S. government's average borrowing cost, that's an additional $10 billion to $20 billion in interest expenses every year. Seems like an expensive way to score a political point.
That said, outright default is not my main concern. Several other things are:
For openers, suppose the federal government actually does reduce its expenditures by 40% overnight. That translates to roughly $1.5 trillion at annual rates, or about 10% of GDP. That's an enormous fiscal contraction for any economy to withstand, never mind one in a sluggish recovery with 9% unemployment. Even contemplating such a possibility is evidence of a dark, self-destructive impulse.
Second, markets now assign essentially zero probability to the U.S. losing its fiscal mind. They'd be caught flat-footed if the threat of default suddenly started to look real, possibly triggering a world-wide financial panic. Remember how markets reacted to the Lehman Brothers surprise? As Mr. Geithner pointed out in New York on Tuesday, "As we saw in the fall of 2008, when confidence turns, it can turn with brutal force and with a momentum that is very difficult and costly to arrest."
And finally, as mentioned, should the view take hold that threats to default are now a permissible weapon of political combat in the world's greatest democracy, U.S. government debt will lose its exalted status as the safest asset money can buy—with unpleasant consequences for the dollar and interest rates.
Fights over the budget are normal and proper in a democracy, especially when the two parties hold dramatically different views. But threatening to default should not be a partisan issue. In view of all the hazards it entails, one wonders why any responsible person would even flirt with the idea.
Mr. Blinder, a professor of economics and public affairs at Princeton University, is a former vice chairman of the Federal Reserve. http://online.wsj.com/article/SB10001424052748703421204576329374000372118.html