The Debt Ceiling Confrontation Is Playing With Fire

 By Simon Johnson

Congressional Republicans are again threatening not to increase the ceiling on the amount of federal government debt that can be issued. On Wednesday, they agreed to postpone this particular piece of the fiscal confrontation, but only until May. The decision to turn the debt ceiling into some form of showdown is a big mistake for the Republicans — and dragging out the indecision is likely to prolong the agony of uncertainty and have damaging economic consequences for the country.

I made these points at a hearing on Tuesday of the House Ways and Means Committee, but unfortunately the Republican majority seems determined to persevere with its destabilizing strategy. (The hearing can be viewed on C-SPAN’s Web site; see the playlist on the right.)

In most countries, decisions about government spending and revenue bring with them an implied, even automatic, decision about how much debt to issue. Spending minus revenue in a year gives you the annual deficit (a flow), while government debt is a stock of obligations outstanding.

Think of it like a bathtub. Spending is water coming in from the tap, and revenue is water leaving through the drain. If there is more spending relative to revenue, there is more water in the bathtub – and the amount of water is the debt. In the United States, for odd historical reasons, Congress makes two separate decisions, one on the flow (spending and revenue) and the other on the stock (the allowed limit on the debt, known as the debt ceiling).

But once you have decided on the rate of flow into and out of the bathtub, the stock at any given moment is a given. So what happens if Congress suddenly decides that there should be a cap on the water in the bathtub, without altering the flow in or out?

To complicate matters, keep in mind that some of these fiscal flows have already been committed, for example in terms of interest payments due on existing debt, salaries for active military personnel and Social Security payments. You cannot suddenly grab more revenue out of thin air.

The main problem is that no one knows what would happen if the federal debt were to hit its legal ceiling.

Would the government be forced to default on some obligations to bondholders? Would there be some other form of default – for example, in terms of nonpayment for goods and services already contracted? Or would there just be complete chaos in our fiscal affairs, a throwback to the mid-1780s, before the Constitutional Convention in Philadelphia and before Alexander Hamilton took the public debt firmly in hand?

In the past, the potential for confusion around binding debt-ceiling limits was well understood. The debt ceiling was therefore raised without too much fuss, and the party in opposition would typically object in principle but not put up a real fight. Plenty of other ways are available for Congress to affect revenue and spending (the flow) without throwing everything into disarray by insisting on a stock of debt that is inconsistent with previous commitments.

This changed in the summer 2011 when some Republicans decided to dig in behind the idea that they could force the federal government to default if they didn’t get what they wanted. For some, this was about forcing big spending reductions. For others, federal government default was actually the goal; see this commentary from July 22, 2011, by Ron Paul, a Tea Party favorite and then a member of Congress. (His son, Senator Rand Paul of Kentucky, is currently opposed to increasing the debt ceiling, even on a temporary basis as agreed this week.)

In summer 2011, I warned about the effects of this confrontation over the debt ceiling, contending that it would create a great deal of uncertainty and slow the economic recovery. I particularly stressed the damage that would be done to the private sector – exactly contrary what the House Republicans asserted they wanted. I also testified to this effect before the Ways and Means Committee on July 26, 2011, although I cannot say my arguments had any impact on Republican thinking.

Recent research by Scott Baker and Nicholas Bloom of Stanford and Steven Davis of the University of Chicago looks carefully at what has generated uncertainty about policy over the last 25 years or so. Their Web site is a must-read, as is the latest version of their paper on the topic (updated Jan. 1). This chart from their paper was a main point in my five minutes of opening verbal testimony.

They find that while the financial crisis of 2008 and its aftermath greatly elevated policy uncertainty in general, the debt-ceiling confrontation in summer 2011 produced the highest level of uncertainty since 1985, when their analysis begins.

Uncertainty about policy is important, because it creates doubts in the minds of people about what is going to happen to the economy. The natural response in the face of heightened uncertainty is to delay making decisions – people don’t go on vacation or buy a car, and business owners and companies don’t hire people unless they absolutely need them.

Slap everyone in the face with such concerns after a big financial crisis and you get a slower economic recovery and fewer jobs.

Most economists would say there is no chance that the United States would ever default; this would be an act of collective insanity far in excess of anything ever seen in this country or anywhere in the world. But what really matters is not the view of analysts and commentators. The real issue is whether decision-makers throughout the economy think that default or some other disruptive event could occur.

The evidence from Professors Baker, Bloom and Davis is clear. The debt-ceiling fight in summer 2011 made people more uncertain about what was to come.

This is consistent with the fact that August 2011 was a very weak month for job creation. According to the Government Accountability Office, this political confrontation also pushed up the cost of borrowing for the government. And uncertainty of this kind increases risk premiums around the world, because investors want to be compensated for higher risks. This put more pressure on European sovereign debt at an inopportune moment, pushing up yields across the troubled euro zone (including, but not limited to, Greece).

In the hearing this week, the Republican line was that the debt ceiling offers a “forcing moment.” This is plainly a threat; otherwise there is no sense in which it is “forcing.” What is the threat? No one knows; even the three Republican witnesses could not agree on what would happen if the debt ceiling were breached.

The threat lies between some form of default and some other form of unprecedented disruption to public finances. Expect uncertainty – perhaps at the level of August 2011, perhaps even higher.

This is an irresponsible way to run fiscal policy. As Sander Levin, the senior Democrat on the House Ways and Means Committee put it, “House Republicans continue to play with economic fire. They are playing political games and that undermines certainty.”

The Republicans should take the debt ceiling off the table.

A version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

26 responses to “The Debt Ceiling Confrontation Is Playing With Fire

  1. Bruce E. Woych

    Background to the big gaming of the system:

    http://thinktank-watch.blogspot.com/2007/12/sir-anthony-fisher.html
    Think Tank Watch
    “Litter the world with free-market think-tanks”
    Sir Anthony Fisher (1915 – 1988)
    Sir Anthony Fisher
    Sir Antony Fisher (1915 – 1988) was one of the most influential background players in the global rise of libertarian think-tanks during the second half of the twentieth century, founding the Institute of Economic Affairs and the Atlas Economic Research Foundation.

    Through Atlas, he helped establish up to 150 other think-tanks worldwide.

  2. Bruce E. Woych

    From Simon’s own back yard: The Peterson Institute for International Economics…………RealTime Economic Issues Watch
    http://www.piie.com/blogs/realtime/?p=3252
    Why Europeans and Americans Are Addicted to Budget Brinkmanship
    by Jacob Funk Kirkegaard | January 9th, 2013 | 11:09 am
    “…in the United States, the medium-term fiscal emergency (as opposed to containing long-term health and retirement costs) is over returning to a non-war economy with tax rates at roughly historical levels. Europe’s problems are far bigger than those in the United States. While Europe must strip its members of critical parts of their national sovereignty, Congress needs merely to pass credible budgets. The fact that a political strategy of brinkmanship with built-in artificial cliffs is necessary to achieve such basic governance in Washington is testament to the American capital’s political dysfunction. Market volatility and crises may be necessary for the drive to unify a continent from the bottom up in Europe. But one cannot successfully run a country if shock therapy is required to accomplish basic government tasks. But at least the recent European experiences in policymaking at the brink of disaster do provide some clues to how events will unfold in Washington in the coming months.

    To understand the essence of political brinkmanship—a political strategy of deliberately pushing a dangerous situation to the edge of disaster in order to compel concessions—the best place to start is nuclear deterrence strategy and in particular Nobel Prize winner Thomas Schelling’s 1966 classic Arms and Influence. Here Schelling describes brinkmanship as “manipulating the shared risk of war…. exploiting the danger that somebody may inadvertently go over the brink, dragging the other with him.” In the euro area since 2010, Armageddon has loomed in the form of a collapse of the euro/euro area financial system. The risk in Washington in the coming months is obviously not war. Rather it is the threat of recession in 2013 (had the fiscal cliff not been avoided), a US sovereign default (if the debt ceiling is not raised), or a US federal government shutdown.”
    Why Europeans and Americans Are Addicted to Budget Brinkmanship
    by Jacob Funk Kirkegaard | January 9th, 2013 | 11:09 am
    http://www.piie.com/blogs/realtime/?p=3252

  3. The Republicans are playing with fire because they want the economy to burn. They think it will heighten their chances of winning control of Congress in 2014.

  4. @Tyler – and how is that not insane and/or not treason?

    playing with “fire”? they’re playing with PEOPLE’S rights to solve stinkin’ problems of POVERTY…

    beat those swords back into ploughshares….or get OUT of Congress.

  5. This is why Obama needs to mint the platinum coin. It could be kept in reserve for use if and when the crazies refuse to raise the ceiling or be used to bargain away the ceiling law entirely. Get rid of the stupid law and I’ll melt down the coin. Otherwise it will be kept in reserve to use if needed.

  6. Bruce E. Woych

    “The real issue is whether decision-makers throughout the economy think that default or some other disruptive event could occur.”
    ==============================================
    http://theeconomiccollapseblog.com/archives/the-coming-derivatives-panic-that-will-destroy-global-financial-markets
    (This was 2012!)
    By Michael, on December 4th, 2012
    ….It would be hard to overstate the recklessness of these banks. The numbers that you are about to see are absolutely jaw-dropping. According to the Comptroller of the Currency, four of the largest U.S. banks are walking a tightrope of risk, leverage and debt when it comes to derivatives. Just check out how exposed they are…
    JPMorgan Chase
    Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)
    Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)
    Citibank
    Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)
    Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)
    Bank Of America
    Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)
    Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)
    Goldman Sachs
    Total Assets: $114,693,000,000 (a bit more than 114 billion dollars – yes, you read that correctly)
    Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)
    That means that the total exposure that Goldman Sachs has to derivatives contracts is more than 362 times greater than their total assets.
    To get a better idea of the massive amounts of money that we are talking about, just check out this excellent infographic.
    How in the world could we let this happen?
    ===========================================
    They labeled the collapse a ‘sub-prime mortgage” issue; but in reality it was derivatives that exploded in our faces…
    Now they talk of a debt ceiling …?

  7. 14th Amendment, Section 4, which states, in part :

    “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”

    The President needs to bring this to the forefront in any discussions with GOP representatives, and he needs to act on its’ provisions, since not doing so is not an election that can be made in a legal, Constitutional sense.

    Now, how are the President gets with this crew of concrete-heads masquerading as elected officials remains to be seen.

  8. ..should be….”how FAR…”

  9. For many reasons, this entire debt ceiling debate is bogus. First and foremost is that whatever the government spends must, by law, be appropriated by the House of Representatives. It’s like someone saying, I am going to buy a new car, an expensive one, and then after the fact, telling the finance company that the car simply doesn’t fit your expenses and you are considering default as an alternative, although no one made you buy it. Or, more to the point, the key issue is much less what the Congress decides to spend, although there is tremendous waste built into that, but the real issue is that they must decide to do what it takes to rev up the economy so that our current taxes will pay for it. Lastly, the debt in a country with the world’s control currency, a fiat currency, can’t ever default defacto, and can mint the trillion dollar coin to deal with it, if necessary. Of course, that can’t do on indefinitely, because sooner or later it would become inflationary, but, temporarily it works well. After all, the FED, since 2008 has created more than 10 trillion in new money, but most has gone abroad or to the banks who were ready to fail in 2008, by its program of Quantitative easing.

  10. @Woych, “They labeled the collapse a ‘sub-prime mortgage” issue; but in reality it was derivatives that exploded in our faces…
    Now they talk of a debt ceiling …?”

    The profit/interest ratio of derivatives is nonexistent. Profit is set to infinity and beyond. Which is where they need to go to create jobs, I guess…

  11. bayardwaterbury

    @Woych: to add to Annie’s comment, Bruce, it was a mortgage (including sub-primes) issue. The CDS’s which exploded the economy were mostly mortgage deriivatives. Even without the derivates, the bonds based on non-existent mortgage underwriting standards would have eventually exploded things anyway, but the derivatives simplly added to the problem essentially as a magnifier, especially when the credit default swaps were added to those. But, the mortgages, as lawyers are wont to say, were the “fruit of the poisonous tree.” Everything based on them was sullied by their complete lack of value.

  12. Sorry, I need a clarification of this “everything based on them was sullies by their complete lack of value.”

    What “everything” are you talking about? The algorithms that bundled them as if the people who wrote the algorithms were the LEGAL holders of the issued mortgages? You can’t be talking about the issued mortgage because the pay off of a mortgage is when DEBT-FREE $$$$ goes into COMMERCE circulation

  13. bayardwaterbury

    I am talking about the complete lack of value of both the bogusly created mortgages with no underwriting standards and the bonds based upon them, and, of course, any derivatives created to support them. This is why the biggest bank’s balance sheets are, without the FASB modifications, essentially still in difficulty and why the FED keeps buying up their trash.

  14. @bayard – gotcha, thanks.

    But then when everyone realized how bogus they all were, they went after the 50 year old crowd with equity and savings….eliminating a million jobs a month to pay off Hank’s stick up note.

    There is absolutely no way to slide out from this because it was PRE-MEDITATED, which as you know, carries a much stiffer penalty than a “whoops, wrong algorithm”…

    8 million people in Israel. Probably double that in FRAUDCLOSURE’s empty real estate space – office redo to condo no big deal, eh? All in the sunshine zone of USA. You do the math – invade Iran because of some PRIVATE fight among plutocrats or move ‘em all out to where they already “own”? Slum lord themselves for a change :-))

    No one is required to do “DELUSIONAL”.

    “god” has a really good GPS to figure out where the chosen ones are…

  15. bayardwaterbury

    @Annie Sorry, but, while your points are certainly valid, you are essentially “preaching to the choir” (that is saying what the rest of us on the site know and agree to). Kind of, in that sense, a wasted “rant”, since there is no argument from us (see Bill Black on this, of course since he was in charge of the S&L successful prosecutions and has written voluminously on the topic of the current Justice Department’s absurd lack of interest). Go to other websites and rant there where people need to be educated — places like the WSJ and Bloomberg. That would prove far more worthwhile.

  16. I don’t understand how we all agree to stand up to old Mcdonald. And then when the time comes, everyone just chickens out.

  17. Most people have already concluded that Washington’s puppets do not serve the best interests of the nation. There are ample warning signs going off now to suggest that anyone banking on fiat currencies and the stability of the global financial system is playing with fire. That’s what should concern us individually. Gold repatriations, currency wars, bank runs, hot wars….and just like 1929, happy days are here again.

  18. Bruce E. Woych

    A Terrible Normality by Michael Parenti
    Posted on January 25, 2013 by dandelionsalad
    http://dandelionsalad.wordpress.com/2013/01/25/a-terrible-normality-by-michael-parenti/
    by Michael Parenti
    “Through much of history the abnormal has been the norm. This is a paradox to which we should attend. Aberrations, so plentiful as to form a terrible normality of their own, descend upon us with frightful consistency.”
    [and]
    Let us not overlook the ubiquitous corporate corruption and massive financial swindles, the plundering of natural resources and industrial poisoning of whole regions, the forceful dislocation of entire populations, the continuing catastrophes of Chernobyl and Fukushima and other impending disasters awaiting numerous aging nuclear reactors.
    “The world’s dreadful aberrations are so commonplace and unrelenting that they lose their edge and we become inured to the horror of it all.”
    http://dandelionsalad.wordpress.com/2013/01/25/a-terrible-normality-by-michael-parenti/

  19. Why doesn’t Professor Johnson tell Americans the truth about their government and their economy? The global economy is on fire and the politicians couldn’t care less. Let’s start telling the truth about the fake recovery and the new housing bubble. The entire ponzi scheme is going into overdrive with mega amounts of printed money. All of this can not end well. The short term fixes and tomorrow’s long-term nightmares. Let’s start talking about what the mainstream media won’t, namly the truth.

  20. bayardwaterbury

    In a small way, Sarah, you are right. Simon, though, has leveled criticism of the European austerians, and as we both know they have now created a new, and perhaps deeper recession, even in Britain with its own currency (the flaw in the Eurozone is that no country has control of a currency, while the plutarchs in each are in control of politics – a dangerous, and perhaps failing mix). One major problem, of more than a few, with the American economy, is our failure to, in any determined policy, to fix unemployment. Presently our economy is being held back by the world, where our best trading partners are in recession, although, I must say, our export markets are doing better than they should. A key way to begin to fix unemployment, is to really rev up our infrastructure spending, which won’t take but a little net spending, if we simply begin to reduce the massive overextension of military spending on global deployments (nearly a thousand bases overseas). That overseas deployment is like revving up foreign aid, since little of that expenditure goes into our economy, while building and updating much needed infrastructure is spending that multiplies itself directly into he domestic economy. And, by the way, if I am not mistaken, these are things which Mr. Johnson has been advocating. This morning on Morning Joe, Paul Krugman, noted Keynesian economist was logically speaking of giving less emphasis to reducing long term debt and restructuring Medicare and Medicaid in favor of this kind of stimulus, and Richard Haass (a non-economist) was giving the tired, old Friedmanian argument against it. Quite a contrast. With our fiat, world reserve currency and current (and foreseeable) low bond rates, now is the time to stimulate and not become austere. We have a long term debt problem, but our debt is very unthreatening in the near term. Even Bernanke has emphasized this.

  21. @bayard – so your high-faluting choir hasn’t chosen to use legal power, either…slapping the victims for *ranting*….

  22. bayardwaterbury

    @Annie — NO slapping here – lol – rants are always appreciated, but perhaps better used elsewhere (my only point).

  23. @waterbury – I am alwasy suspicious of those who demand Zen State conversations – conversations that are being conducted in order to support escape from justice.

  24. Simon Johnson blames the debt ceiling debate for creating uncertainty, but uncertainy on Main Street is driven by the nebulous monstrosity known as Obamacare. Even unions are demanding waivers in order to avoid dumping all their members on state exchanges, which would bankrupt most states.

    There’s an oil boom going on in North Dakota and uncertainty over unilateral actions by the EPA threatens to undermine investor confidence. Not to mention the EPA’s March 27, 2012 arbitrary cap on CO2 emissions from coal plants, which severely limits the U.S. economy’s ability to utilize its 800 year supply of coal. But that’s great for Wall Street because more U.S. coal, and the low cost energy it provides, will be exported to their Chinese partners who don’t have to play by the same rules. And this is called competition.

    Bruce E. Woych points out the “jaw dropping” negative equity positions of America’s largest banks. The debt ceiling debate is a smoke screen created by bipartisan criminals who are covering up the astronomical moral hazard posed by Wall Street banks, which are still Too Big To Fail. Evidence of the moral hazard is provided by Stanford finance professor Paul Pfleiderer. In the following link, he said Moody’s rating of BoA debt is five notches above what it would be without gov’t/taxpayer support. So when the house of cards falls down, all of Simon Johnson’s sensible suggestions will do nothing to protect taxpayers.
    http://www.c-spanvideo.org/clip/3344569

    For real solutions go to:
    http://www.standupforyourrights.me/?p=1047

  25. Blinder put this well in his wall street journal article: “In short, the consequences of hitting the debt ceiling are too awful to contemplate—worse even than going over the fiscal.” His new book After the Music Stopped also provides some insight into chipping away at the federal debt (there’s a good preview of it on the book’s facebook page: http://facebook.com/afterthemusicstopped and amazon page: http://tinyurl.com/afterthemusicstopped-amazon)