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The Folly of U.S. Debt Brinkmanship

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
July 1, 2011

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The United States is now only one month away from the date on which the Obama administration says it will exhaust its legal authority to issue government debt. To avoid bumping up against that ceiling, Republicans and Democrats must overcome their differences and pass legislation to raise it. But compromise appears elusive. Far from narrowing the gap, the two sides are indulging in the sort of posturing that will make a deal harder to reach.

From the start of the negotiations, Republicans have taken the position that they will only permit a higher debt ceiling if Democrats concede deep spending cuts. The Democrats, for their part, have agreed that spending cuts are reasonable; but they want these to include cuts for the Pentagon, and they want to balance spending cuts with tax increases. Republicans have resisted.

In recent days, however, they have done more than just resist. Senate Republicans have expressed support for a constitutional amendment that would require the federal budget to be balanced--an attempt to legislate away the possibility of future deficit spending, even in severe economic downturns that might warrant it. Further, the balanced budget would cap federal spending at about 18 percent of the previous year's GDP, an impractically restrictive cap given that federal spending has averaged 21 percent of GDP over the past decade. Some Republicans are suggesting that the balanced budget amendment might be a condition for raising the debt ceiling. Since an amendment is a nonstarter for Democrats, this threatens a train wreck.

As the Republicans have hardened their position, President Barack Obama has hardened his rhetoric. At a news conference on Wednesday, he demanded that the Republicans stop getting in the way of ending tax breaks for "millionaires and billionaires." Referring to the Republican leadership, he complained that "everybody else has been willing to move off their maximalist position and they need to do the same."

Perhaps not surprisingly, Obama's salvo triggered a counter-blast from Republicans. The party's Senate leader, Mitch McConnell, declared that the issue was not rich versus poor, as the president had framed it, but rather whether Washington would be held accountable for its profligate spending. "The president's remarks today ignore legislative and economic reality," chimed in Republican House Speaker John Boehner. "His administration has been burying our kids and grandkids in new debt."

Both sides are playing chicken. Both may swerve enough at the last minute to avert a collision. But games of chicken can be hard to exit. Leaders can get trapped by their own angry rhetoric: Having denounced your opponents as extremists, it's hard to explain to your partisan base why you decided to compromise with them. And recall what happened in the famous game of chicken in the James Dean movie, Rebel Without a Cause--Buzz Gunderson got his jacket tangled in the car door handle and drove off a cliff.

[I]f the fight over the debt ceiling turned the world's risk-free benchmark into a risky asset, pandemonium would ensue. Investors would not know which way to turn.

If no compromise is possible, the government will face some awful choices. Unable to borrow, it could cut spending until no borrowing is necessary. But with the budget deficit running at about 9.3 percent of GDP, the cuts would need to be enormous. Not only would government workers be laid off and multiple programs interrupted, but the economy would go into a tailspin. The loss of government demand, coming on top of weak private demand because of the lingering effects of the financial crisis, would create a disastrous shortfall of spending in an economy already growing below its potential. The resulting recession would drive already acute unemployment to even higher levels.

To avoid enormous cuts in spending, the government might consider the other option: It could free up resources by not repaying some of its creditors. But this policy--a controlled default--would be even more calamitous. Investors who hold U.S. government bonds would be panicked. As they dumped their holdings, bond prices would fall and bond yields would rise, meaning that the cost of servicing government debt would go up and the nation's already shaky public finances would deteriorate still further. A vicious cycle would ensue, with a weak budget position boosting the cost of debt service and higher debt-service costs weakening the budget position. What began as a controlled and limited default could end up in a chaotic general one.

Meanwhile, the disruption to financial markets would be instantly disastrous. Investment portfolios around the world are constructed on the assumption that U.S. Treasuries are a risk-free asset. For example, other bonds are assessed according to their "spread"--meaning the gap between the interest they pay and the yield on supposedly riskless Treasuries. But if the fight over the debt ceiling turned the world's risk-free benchmark into a risky asset, pandemonium would ensue. Investors would not know which way to turn. They might hide from all risk. Think of the market meltdown following the Lehman Brothers bust--and then double it.

The fact that gridlock in Washington renders such prognostications necessary is itself damaging. Since the financial crisis, authoritarians and state capitalists have lost their respect for the United States. Market capitalism is in disrepute; democracy is discredited. The budget fight is only deepening such feelings. Democrats and Republicans should remember that the world is watching.

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