Hurtling towards a debt ceiling disaster

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.

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:

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.

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.

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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  1. You need to be more precise…”Furthermore, as Richard Koo argues, slashing government spending in the middle of a balance sheet recession is nothing but a folly”


    Tim Geitner said a few days ago:

    “We don’t have the ability (because of the overhang in housing and the problems in the financial sector) to artificially engineer a stronger recovery.”


    ….the latest report from Hoisington Investment Management, the highly regarded US bond fund manager, makes it clear that QE3 is likely to make matters worse.

    The report, which was co-written by the firm’s founder, Van Hoisington, and economist Lacy Hunt, argues that the most recent US economic recession was not caused by a lack of demand. Instead, they say, it was due to the excessive build-up of debt relative to GDP. The trouble is that this type of contraction, which was first analysed by US economist Irving Fisher, can’t be cured by massive government spending or central bank stimulus. Instead, “only a time-consuming and difficult process of deleveraging corrects this economic circumstance.”

    Now if the Fed is getting this advice and Geitner admits the ‘folly’ of Governments trying to engineer recoveries…then it would seem the tide is turning and people do not believe the Government has the ability to help any more.

    All theyw ill do is misallocate resources in a vain attempt to prop things up a little longer…all the while helping bondholders at the expense of tax payers and savers

    • Geithner is speaking nonsense here. Of course government spending can boost aggregate demand. The question is what the consequences of that spending will be. Will it be inflationary? Will it lead to malinvestments, etc?

      When you have 10% of the workforce unemployed and massive spare capacity, government spending is not going to cause inflation. In the longer term, it’s a different story, as I’ve argued before. They need to get healthcare spending under control, etc.

      I used to speak to that guy at Van Hoisington when I was in financial journalism. Very smart guy. He’s right that a time consuming and difficult process of deleveraging is necessary. We just disagree about the role of government while that adjustment is taking place.

      • “When you have 10% of the workforce unemployed and massive spare capacity, government spending is not going to cause inflation”

        Of course it can. For you to be right, every industry must have about 10% unemployment, but this is not the case. Some will be running at far less, some far more. If new funds are introduced into the hands of private investors, the odds are that most of this will go into industries that are currently doing the best, which are likely to be those with strong employment already. This would exacerbate any inflationary problems that may already exist.


        • Ahhh the old output gap fallacy…

          Timbo is right too, there is no way to ensure that the money will creat demand in the sectors that have “spare capacity” and more likely to just fuel inflation.

          Geitner also did no simply say that Government spending cannot stimulate demand…it can, but it cant engineer “A RECOVERY”

          Koo is right that we can kick the can down the road for a few more months (years even) but we will not have a genuine recovery on the back of Government stimulus. The back log of debt is far too big for Government ot counter it without ruining their currency

          Better option…the one that will occur anyway, is debt moratorium

          • ” there is no way to ensure that the money will creat demand in the sectors that have “spare capacity” and more likely to just fuel inflation.”

            You’re saying that government spending in specific areas can’t generate demand in those areas even if the spare capacity is there?

            I’m not sure I follow that. I can understand that the distributional impacts of monetary policy stimulus are uncertain, but you sound like you’re saying that government offers to buy output will be ignored, even if there is plenty of output lying idle in those areas.

        • Surely it depends on how it’s spent. A fiscal policy response could be targetted precisely at those industries which are not doing well.

          The trouble is that the US government is under the impression that QE somehow adds to aggregate demand, which of source it doesn’t.

          • You could try, but why would you want to? The industries that have the most spare capacity are those that need to shrink.

            The building industry in the U.S. is having a hard time, but why stimulate it? The U.S. doesn’t need more houses, and it doesn’t need that many people working in the building industry. The current U.S. depression includes a shift away from debt-fueled house building/buying, and the economy needs to adjust. Stimulating the building industry just provides jobs to people who should be re-training in other areas, and kicks the can down the road…. meanwhile adding more debt.

            If fiscal policy supports a particular industry, it is saying that the number of people employed + those looking for work is the number required in the medium term. Nobody can make an accurate prediction of consumer’s preferences 5 years from now.

          • There is no need to prop up dying industries with fiscal stimulus. This is a straw man argument. But while the deleveraging process is playing out, the government can play a role cushioning the impact. Just a couple of examples:
            – Retraining programs for people who are going to have to move into new industries
            – Infrastructure (have you ever used LAX or JFK airport?? or seen the dilapidated state of New York’s subway system?)

            Neither of these involve picking winners or being prescient about consumers’ future preferences. They are investments in the country’s future productive capacity.

        • Timbo – Where are these industries of which you speak that are running at full capacity and where wage inflation is going through the roof? They don’t exist.

          • First, I’m not claiming that there is. I’m just countering the claim that inflation cannot occur, when clearly it can.

            Second, is there really no industries in the U.S. getting wage rises? I don’t study the U.S. in much detail.


          • Tim — Of course you’re right that some industries are always doing better than others. You can see unemployment rates by industry here:
            Interestingly “Management, Business and Financial Operations” has the lowest unemployment rate. I wonder if that has anything to do with the bank bailouts…?

        • Timbo,

          Well said. Those who rely exclusively on aggregates miss the really important stuff happening at the micro level.

          Of course some industries are doing better than others, just as some states are doing better than others. I wonder if those people who deny this are the same ones complaining about the “two-speed economy”?

          • “Those who rely exclusively on aggregates miss the really important stuff happening at the micro level.”

            The fact that specifically-targetted fiscal policy is being discussed obviously excludes present company from that statement.

      • Excess reserves deposited with the Fed have gone from basically nothing to $1.5tr. So the effects of QE have not really filtered through to the economy.

        Additionally there has been a race to the bottom for many of the major currencies, so just observing that the USD index hasnt depreciated is a very basic and pretty useless observation.

        The reserve currency status of the US has exported a great deal of its inflationary pressure to the outside world, this effect can be seen in rising food and commodity prices that arent linked to increased demand.

        The analysis in that article ignores these factors.

        • The article provides an empirical rebuttal to the claim that expanding the Feds balance sheet smashes the dollar and causes inflation. It is brief and doesn’t seek to do any more than that. As with most of these types of discussions it is a essentially a case of empiricism vs a belief system.

          I only provided the link because Stavros mentioned the Hoisington stuff and it is discussed in the comments section. The article itself is not actually relevant to this debt ceiling article from RA.

          Excess reserves deposited with the Fed have gone from basically nothing to $1.5tr. So the effects of QE have not really filtered through to the economy.

          On the contrary QE has done exactly what was predicted by prag cap and others months ago …for reasons that come back to banks not being reserve constrained. In other words those that understood the lack of a reserve constraint predicted it correctly. Those that were themselves constrained by a belief system that said banks first need reserves to be able to lend have been surprised by the QE2 outcomes.

    • “We don’t have the ability to artificially engineer a stronger recovery.”

      Nonsense, Tim has the ability but not the will or willingness to help anyone on the main street. He can engineer a strong recovery in Wall Street alright – the bonuses keep growing.

      “(because of the overhang in housing and the problems in the financial sector)”

      That actually does not make any sense. How is Treasury action impaired by problems in the financial sector?

      Anyway, problems in the financial sector, eh? What happened to all the TARP money and the stress testing that Timmy did to ensure that banks(well,banksters) are fit as a fiddle?

      I cannot believe such insane comments go unchallenged in the mainstream press.

      • I cannot believe the Keynesian claptrap that has proven to have failed can keep getting sprouted…this is the first time Geitner has been frank about the siutation.

        Debt reduction is the key….not increases in debt to prop things up.

  2. I like this interactive chart on PBS

    You can scroll the bar to see the income and outcome for the days in August.

    Tim Geithner has been misquoted. The full interview transcript can be seen here

    The full quote is:

    SEC’Y GEITHNER: You know, this took a long time to build up, the problems that caused the crisis. It’s going to take time to fix. Just think of it this way. This was a crisis caused in part because Americans borrowed too much, banks took on too much risk. They–we built too many homes, more than we could afford. We were living beyond our means for a long period of time. And part of what makes this so hard, part of what makes the recovery slower is because people are going back to living within their means. They’re spending less of their share of income, they’re saving more. And we don’t have the ability, because of the overhang in housing and the problems in the financial system, to do–to engineer artificially…

    MR. GREGORY: So in other words it’s unfair to demand…

    SEC’Y GEITHNER: …a stronger recovery.

    Economist like Paul Krugman will point out he US stimulus was too small to matter. However, anything larger is politically impossible because of filibuster in the US Senate. The mistakes of the Great Depression is repeating itself due to political reality. People wants jobs. People wants a smaller deficit, and they can’t see how the two is opposing each another.

    In regard to Government spending, let’s see. Here is the US government recovery website:

    The 150 billion dollar is responsible for about 560K jobs. That’s around 270K US per job!! That’s hardly value for money.

    • “The 150 billion dollar is responsible for about 560K jobs. That’s around 270K US per job!! That’s hardly value for money.”

      Hmmm.. I wonder how many jobs were created due to the Bush tax cuts for the billionaires and 1/3rd of the stimulus that were tax cuts.

  3. The Republicans and the Democrats each have to choose between their respective bases and default.

    The Republicans get to blame Obama if everything goes up in smoke, so they will almost certainly not give in.

    The Democrats will be totally unelectable in 2012 if they don’t stand up for the social programs they fought so hard to create.

    And Obama doesn’t appear to know what to do or, if he does, how to do it. So the chances have to be rated very high that the debt ceiling will not be lifted. Each side in the political process has too much to lose if they make any concessions, and, accordingly, neither side will budge unless the other also is willing to move. It is not just a zero-sum game. It is a game being played by the maxim that says “I can only win if you lose.”

    America has been a nation divided for many years. The full depth of the divide is now being exposed for all to see. It is as if Americans do not believe in each other any more. Mistrust, envy and baleful rebellion are their everyday language now.

    If they do not default on their debts, it is obvious to the world that Americans have at the very least defaulted on their duty to both respect each other and try to live up to the ideals they think they represent, and extend each other the benefit of the doubt.

    I don’t believe they are going to pull together in time. Chaos is just days away.

    • David,

      Wow if what you say happens, and I don’t disbelieve you, we’re in for some bad times. I can see why you have this view, but I never thought it would happen.

      I’m with you, and think there is going to be a crash of some sort. But I hope it’s not a default in the US, as I imagine credit markets really will freeze worse than GFC 2008 (I still think were in the GFC BTW, so no GFC V2 in my mind).

  4. “I could end the deficit in five minutes. You just pass a law that says that any time there’s a deficit of more than three percent of GDP, all sitting members of Congress are ineligible for re-election.”
    – Warren Buffett

  5. David – This is exactly why I am worried, and you explain the politics of it better than I could have. Obama has already moved considerably to the right, risking the loss of his base. And even that offer was rejected outright by the Republicans. Meanwhile, if the Republicans agree to any revenue increases at all, they lose the support of the Tea Party. The incentives are all lined up in a very bad way, and it really is hard to predict what will happen. That’s why I think we may be headed for a TARP type scenario. It might not be until the markets blow up that we get a resolution.

    • But to put this into proper context this is not Greece despite the breathless comparison in the MSM from people who really ought to know better, because as you have said, what is occurring it is self imposed. Thus we see bond yields sky rocketing in PIIGS and falling in the USA (with coverage higher than it has been for quite some time).

      Which is not to say that some unpredictable outcomes couldn’t eventuate if they don’t get their shit together, but IMO it is not a TARP type 800 point calamity in the waiting.

  6. RA, a great read. The one thing I don’t get is, where does this all end? Reading your post I get the impression that US default is inevitable, it’s just a matter of when. Can you paint us a scenario in which this ends well? Is it that the US raises its debt ceiling, engineers a sustainable recovery and then pays down all this debt over a long period of time? Against the backdrop of a balance sheet recession?

    What odds do you put on a US default? Gold starting to look cheap at $1600…!?

  7. I had no idea that the differential between committed spending and income was so huge.

    It is the equivalent of an individual that has committed spending of $320 per day and an income of only $120 per day and is borrowing that difference and never paying it back. If you were running a bank, would you lend any money to this person?

    Whatever they do now, default in the next decade is inevitable.

    • “It is the equivalent of an individual that has committed spending of $320 per day and an income of only $120 per day and is borrowing that difference and never paying it back.”

      Except in this case the individual can create the $200 whenever they want. Or create the interest and pay it. The only thing stopping them is the self-imposed debt ceiling, which is a completely arbitrary, combined with a self-imposed rule that they have to issue debt to match spending.

  8. MissMoneyPenny

    For a bit of fun (and to get my tax return done in a timely manner) I thought I would download etax, chase group certificates etc and try and get my tax done before congress resolve their debt ceiling issues.

    My financial affairs are nowhere near as complex as the US but I still manage to run a surplice each day/month. Maybe if I could print money I may run thing in this house differently……

  9. Surely all this “more debt” sentiment is nonsense, ridiculous misguided nonsense.

    Personally, i don’t care how we say this and that can be engineered this way and that way….SO THAT we can basically wriggle out of the mess we’ve all gotten ourselves into.

    I can’t help but think that for all of us – economists, pollies, lay-people, commoners – we are entertaining the idea that maybe we can “fix” this, that we can avoid the consequences of our actions, if we are just targeted enough, united enough, clever enough…it’s a philosophy, a belief that seems to undergird virtually all thought and discussion, regardless of the party/entity concerned.

    But we can’t escape the consequences of our collective actions.

    And if we try to, we will only make things worse in the end, whilst more prolonged and painful in the duration.

    It’s a human and moral system – not a mechanical system. Hence, the problems are ultimately those of humans and morality, not of engineering, cleverness, “targetedness”, etc. You can’t engineer people, so you can’t escape this.

    It’s only a question of nature, magnitude and duration for the consequences – not “if” but when.

    And hopefully we’ll recognise that the “sin” of excessive debt (and, dare i say, unjust systems) it only solved by “repenting” from the belief systems that generated the problems, so to speak.

    But part of our “problem”, really, is that we are trying to escape the consequences, as if that were the “problem”; where all along the real problems are other fundamental things entirely…but we don’t want to address those…so we continue on, can-kicking, thinking, “If only X and Y, then we’ll be right”.

    Look, it probably won’t be “too long” before the world is giving up on capitalism, because “it doesn’t work”…without having really given moral and just systems a try!

    And, for the arbitrarily-defined sub-set of human experience and interaction we call “economics”, more debt can’t solve problems caused by too much debt – not matter what arbitrarily-bounded and philosophically-isolated and mathematical arguments appear to tell us…

    …and that solution itself is arbitrarily limited to exclude the real solutions – those that are moral in nature.

    Destruction of money that should not have otherwise justly existed is one of the only things that can be done – IF we want to preserve a system that has any resemblance of free-market capitalism…else we’re surely heading down the road to another paradigm.

    /steps down from soapbox

    Thankyou, that was therapeutic! 😉

      • …probably…

        And that might be a market-forced action, rather than politcal and socially forced action…

        But also, and mainly, from my POV: that partial or even full, in some cases, Default is inevitable – and EVEN beneficial…else, eventually, we will abandon our “free” (I say that lightly) systems in favour of more centralised systems (take you pick).

        My 2c