Debt Ceiling Impasse Part 2

by robekulick

There is a lot of confusion and misinformation about the debt ceiling debate and what it means, so my purpose in this entry is to try and clarify what’s going on.

First and foremost, last I check the  intrade ( probability of a deal being put together by the end of July is about 34%. Thus, it seems likely that a deal will not be reached in time for August 2nd and the Federal Government will no longer have enough money to pay all of its bills.  So what happens at this point?

Contrary to some of the hysteria out there, the United States will not be in danger of a true default on its debt obligations. As Richard Posner explains here,  although the US will not be able to borrow anymore the government will have enough money from Federal taxes to pay the interest it owes on US bonds. This is very important because if they US were to stop paying the interest on its bonds and enter a state of default it could wreak havoc on the world financial markets since so much of the financial world is based on the safety of US government debt.

What will happen on Aug. 2 is the US will run out of money for many other programs and will effectively have to “shutdown” the government as happened in 1996. The US will also have to stop paying entitlements like social security and medicare. Of course, since seniors vote and the AARP is one of the strongest lobbying outfits out there once this happens the political pressure for a compromise will be immense and indeed, the intrade probability of a deal being put together by the end of August are about 75%.

Even though the US will not default on its debt, there are three potential sources of economic harm that come from not reaching a compromise on the debt ceiling. First, people may start to sell off their US bonds, driving interest rates up and stocks down. Second, the lack of entitlement payments could reduce aggregate demand. Third, one of the bond ratings agencies (S&P is doing most of the saber rattling) could downgrade US debt from its AAA (the best rating available) status.

Now if this impasse were to go on for a long time (1) and (2) could become serious problems. But it is almost definitely the case that as soon as financial markets and economy start showing signs of reacting to the impasse in Washington, the pressure on the government to do something will force a compromise (think TARP bailouts after the stockmarket fell precipitously).  Indeed, what’s fascinating is that despite the media hysteria about this issue, financial markets have hardly reacted.

The third issue, of a ratings agency downgrade is more interesting. A couple of days ago, my colleague Billy Schwartz (hopefully soon to be a co-blogger) made the argument that since people in the financial markets would anticipate any downgrade, a downgrade should already be priced into the markets. Under normal circumstances, Billy’s economic logic is impeccable. However, there is an institutional complication to the normal economic logic.  Many money market funds, pensions funds, and other institutional investors are obligated to hold AAA rated securities. If S&P downgrades the government’s debt, it is possible that some of these institutions will be forced by their own rules to sell their US debt potentially driving interest rates up if the selling is significant.

Now, it strikes me that downgrading US debt from AAA when there are still mortgage CDO tranches with AAA ratings is pretty absurd. However, with egg on their face from the financial crisis ratings agencies may act aggressively just to show how tough they’ve become. And again, intrade seems to believe at the moment that there is almost a 50 percent chance S&P downgrades US debt if there is no compromise. Also I saw yesterday, that S&P is saying that for them not to cut the US debt rating, the increase in the budget ceiling will have to be accompanied by $4 trillion in reduced spending and tax increases. In the long-term, if S&P chooses to go through with this, I think they’ll only end up bring further doubt on their financial acumen. Either way, although a downgrade would be bad, it too would promote compromise, so it seems to me that in the near future this issue will be resolved, although the hysteria level will probably crescendo every week that it goes on.