Playing chicken with the debt ceiling is a dangerous game

Jun 16, 2011

by James Hamilton, Econbrowser

Making a political game out of the debt ceiling is playing with fire.

Treasury Secretary Timothy Geithner has been warning of serious repercussions if the debt ceiling is not raised, for example, in this letter written May 13 to Senator Michael Bennett (D-CO):

Failure to raise the debt limit would force the United States to default on these obligations, such as payments to our servicemembers, citizens, investors, and businesses. This would be an unprecedented event in American history. A default would inflict catastrophic, far-reaching damage on our Nation’s economy, significantly reducing growth, and increasing unemployment.

A default would call into question, for the first time, the full faith and credit of the U.S. government. As a result, investors in the United States and around the world would be less likely to lend us money in the future. And those investors who still choose to purchase Treasury securities would demand much higher interest rates, reflecting the increased risk that we might default on our obligations again.

Default would not only increase borrowing costs for the Federal government, but also for families, businesses, and local governments – reducing investment and job creation throughout the economy. Treasury securities set the benchmark interest rate for a wide range of credit products, including mortgages, car loans, student loans, credit cards, business loans, and municipal bonds.

Others question whether it's really such a big deal. Here's former Governor Sarah Palin (R-AK):

I don't believe Tim Geithner as he cries wolf for the fourth time now, telling us that there is a drop-dead date and crisis will ensue, and economic woes will befall us even greater than they already are if we don't increase the debt limit.

The truth is that there is no drop-dead date. This is because the debt ceiling is an inherently mushy concept. There are plenty of accounting gimmicks that the government can use, and is using, to postpone the crisis Geithner sketched in the quote above. Indeed, in his letter to Congress dated April 4, Secretary Geithner described the measures the government is using at the moment. These derive from the fact that much of the debt that the government has accumulated is owed to itself or to other branches of the government, such as State and Local Government Series Treasury securities, the Civil Service Retirement and Disability Fund, Government Securities Investment Fund (G Fund) of the Federal Employees' Retirement System Thrift Savings Plan, and the Exchange Stabilization Fund. Intragovernmental obligations subject to the debt ceiling are essentially IOU's from the government to itself, which could in principle be swapped with less formal IOU's in order to stay within a statutory ceiling. The government can also redirect funds appropriated but not spent or postpone accounts payable and tax refunds.

Keith Hennessey, who served as Director of the National Economic Council under George W. Bush, warned last April that the mushiness of this boundary is precisely what makes the game of brinkmanship very tricky:

A temporary continuing resolution has a hard deadline, while a debt limit increase does not. Everyone knew that if no agreement was reached and no new CR was enacted by midnight last Friday, the government would shut down at that moment. That precise deadline created pressure on both sides to make decisions.

The debt limit works differently. You have to increase the debt limit, but there isn’t a precise deadline. Treasury has tools to manage its cash and borrowing from financial markets. There are tricks Treasury can use to dip into other, special purpose emergency reserves of cash (or other borrowing authorities) so that the debt subject to limit doesn’t increase quite as quickly as under normal operations.

I know the pressure to define every problem in terms of a "drop-dead date." I talk to reporters all the time who always want me to summarize any situation, whether it's government debt, oil prices, or the Fed's balance sheet, in terms of when the "tipping point" is really going to be reached. I always try to explain that the world doesn't work that way. Instead, there are risks that gradually increase as the pressures become more significant. How far is too far? I don't know. But why would you voluntarily choose to pile up the risks?

I don't believe the consequences will necessarily wait until the currently reported deadline of August 2. I shared the concern expressed on Monday by Free Exchange at this account:

Some of Wall Street's biggest banks are preparing to cut their use of US Treasuries in August as a precaution against any turbulence that could follow if warring Republicans and Democrats fail to increase soon the US debt ceiling, a senior bank chief said.

One strategy, which bank executives only agreed to discuss without attribution due to the political sensitivities related to discussing Treasury debt, is to have more cash on hand to put up as collateral against derivatives and other transactions, decreasing the financial system's reliance on Treasuries.

If buyers of U.S. Treasuries are already getting nervous and making plans for alternatives, I would have some concerns, about how the dynamics of a Greek default could play out if it were to occur, for example, next week, even though we still have a month to go before the supposed drop-dead date.

Josh Barro summed up this way:

It's important to step back and consider the stakes here. Republicans say it is important, above all else, to rein in federal government spending. But the risk with excessive spending is not that government will literally become unaffordable or that we will be unable to service our debts....

It does not make sense to create a risk that U.S. Treasuries will be dislodged as the world's safe-haven investment as a strategy to shift the size of government by a percentage point of GDP or two. Winning this fight is not so important that it makes sense to throw caution to the wind, but that is what Republicans in Congress appear willing to do. The gamble looks even worse when you consider that a debt-limit-impasse-gone-wrong would not necessarily lead to Republicans getting their way on the long-term fiscal adjustment.

I agree. Republicans have picked the wrong line to draw in the sand.

James D. Hamilton is Professor of Economics at the University of California, San Diego.

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