Hurtling towards a debt ceiling disaster

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Another day passes without any progress in negotiations on raising the US debt ceiling…

And the stakes are rising. From Thursday’s Wall Street Journal:

Credit rating agencies moved closer to an unprecedented downgrade of the U.S. government’s debt amid deteriorating talks in Washington, with President Barack Obama abruptly walking out of a key meeting Wednesday with Republicans seeking a deal to raise the federal borrowing limit.

Moody’s Investors Service said it was reviewing the government’s top Aaa bond rating for a possible downgrade, citing the “rising possibility” that the government’s $14.29 trillion borrowing limit won’t be raised soon enough to prevent the U.S. from running out of money to pay its bills.

In addition, ratings agency Standard & Poor’s privately has told lawmakers and top business groups it might cut the U.S. credit rating if the government fails to make any of its expected payments—including Social Security checks—even if it makes all its debt payments, people familiar with the matter said.

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As I have argued before, the debt ceiling itself is a nonsensical construct, and as such, the current crisis is totally unnecessary. Furthermore, as Richard Koo argues, slashing government spending in the middle of a balance sheet recession is nothing but a folly. Nevertheless, let’s not get into that today. The consensus is still that the politicians will cobble together some kind of solution ahead of August 2, when the Treasury is forecast to run out of cash to pay the government’s bills.

However, in my opinion there is a small but rising chance that the sheer incompetence of Congress will lead to a disastrous outcome.

As Harvard University’s Jeffrey Frankel puts it:

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In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken. Both intend to jump out at the last moment. But the other guy miscalculates, and goes over the cliff with the car.

This is the game that is being played out in Washington this month over the debt ceiling. The chance is at least 1/4 that the result will be similarly disastrous.

Let’s quickly recap the farcical events of the past couple of weeks. First, President Obama proposes a massive $4 trillion of budget cuts over the next decade in exchange for Republican support for raising the debt ceiling. This reportedly included reductions in social security and major cuts to Medicare. In other words, a step towards the dismantling of the welfare state that every Republican dreams of. But because 25% of the $4 trillion came from tax increases (mostly the closing of loopholes and deductions), the Republicans said NO.

In the next development, Senate Minority Leader Mitch McConnell has unveiled a proposal that would allow President Barack Obama to raise on his own the federal borrowing limit by $2.4 trillion in three installments before the end of 2012, unless two-thirds of Congress votes to block it. If this doesn’t make any sense to you, it’s because it doesn’t make any sense.

In any case, what happens if we get to the deadline without a deal? A presentation just released by the Bipartisan Policy Center paints the picture.

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First, let’s take a look at the Treasury’s projected cashflows for August 3. As you can see, immediate cuts to some fairly high profile programs would be required. This tool from Bloomberg Government let’s you play around with the numbers. It ain’t pretty.

Faced with the need to make immediate cuts, what would the Treasury prioritize? Undoubtedly, interest and principal payments on the national debt. As you can see below, the Treasury will have to roll over close to half a trillion dollars of debt in August alone.

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As I said before, the main scenario is that the Republicans and Democrats cobble together some kind of makeshift solution before August 2. However, the extremity of the Republican’s negotiating position (zero tax increases, period) is going to make it difficult to reach any kind of reasonable solution. Especially when Obama has already made huge concessions to the Republican side.

At the end of the day, it may take a bout of market volatility to spur Congress into action. You might recall that in September 2008, Congress initially rejected the TARP bill to rescue the banks. It was only after that vote triggered a near 800 point collapse in the Dow Jones that the politicians reconsidered.

This could get very messy.

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