Armageddon and the US debt ceiling

Now that it is obvious that my previous post on Grover Norquist has pretty much come to pass, there are all sorts of pundits predicting what will happen if the US defaults on it's debt next week.  I saw a prediction by Credit Suisse on the CNBC website that stocks might fall by 30% and the US economy would contract by 5%.  Well frankly I think that is a bit of an over-reaction.  The US is not Greece, and although the US debt levels are high this is not a case of "can't borrow to pay", this is only potentially a case of "can't get our political act together, won't pay", which is quite a different thing.

My point is that a Greek default is now becoming a foregone conclusion and therefore causes systemic problems as people start to worry about the solvency of Greek banks if they hold Greek bonds and therefore  whether Greece can stay in the euro area with a growing economy given that it has had inflation that has been far above its partners for a significant period of time. The US is just not in that position and although some in the Tea Party and for that matter in the UK Conservative party appeal to the example of Greece as a reason why the US and the UK need to really tighten the fiscal screws, the logic frankly just doesn't carry over, and there are several reasons for this which I details below.



First, even if the political parties run out of time and cannot strike a deal, a US default is just not a foregone conclusion yet - as the FT made clear in an excellent article yesterday, the 14th Amendment of the US Constitution states that “the validity of the public debt of the United States ... shall not be questioned”. The Supreme Court, in a case back in 1933 when the US was trying to escape paying its gold obligations after it left the gold standard, stated that Congress has to honor it's own contracts, and that that means that the interest payments must be made, whatever else might happen. So that implies that, quite simply, a default cannot happen, and that cuts will have to be made to government to hold spending down so that it does not exceed revenues. If Congress is obligated to pay certain payments then presumably the President must have some role in declaring that Congress is out of order and breaking the law and can issue an executive order to raise the debt limit.

Second, there are other (rather "clever" and obscure) options, described in the excellent piece on the CNN website by Jack Balkin.  I rather like the idea of asking the Fed to issue 2 jumbo sized platinum coins worth $1 trillion each - which can then be credited to the government's account!

But let's get to the "Armageddon" option of a default - some now think that it's not such a remote possibility, and have looked at probabilities of what could happen and the implications of this.  Perhaps the most publicised analysis over the last 24hrs has been that of Willem Buiter (who used to teach me when I was a graduate student) and Ebrahim Rahbari of Citi which was neatly summarized in the FT Alphaville today.  Although a downgrade is clearly not going to be good news for future borrowing or rollover of the current stock of debt, the 2 economists do some serious "back of the envelope" calculations that make clear that GDP would not fall by a third, and that by their calculations the amount would be between 0.2 to 0.5% fall.  Now noone wants GDP to fall given the fragility of the current recovery, but that is a far cry from the 5% fall predicted by Credit Suisse.  In their research Buiter et al put weights on 5 different scenarios and they got them a little askew (in my humble opinion), as given the politics, the one now most likely is a debt default, not Scenario 1 ( - no default as a bill is passed by Congress). Plus there is another scenario which I will label Scenario 6: "The Federal debt ceiling is not raised in time and the US sovereign does not default". This might come about because of some obscure legal manoevering (see above) that the White House might be able to manage, and although it might trigger a downgrade due to the market impression that it is "kicking the can down the road", it may nevertheless be a feasible option.

So what will happen in the event that things don't go well next week? If a political deadlock with no obvious escape means that fiscal policy puts a break on US growth, the Fed is still able to swing into action with a QE3, something that might be necessary if the legality of the President's options is questioned. So I think the prospect of the US stockmarket falling by 30% is just not grounded in reality - and certainly not for any sustained period of time.

I think that a default and downgrade is now the most likely scenario, but I also think that there is an understanding in world markets that this is not a reflection of an unhealthy US economy, this is just a reflection of the dysfunctional politics that the US now finds itself in, due to the Tea Party.  There is one silver lining to all the hysteria of recent days though - at least a public debate is now starting to happen in the US as to what should be done - and that, I believe, is a positive outcome.

How one man could (at minimum) destroy the US economic recovery

The US talks on raising the debt limit now enter a critical phase as the August 2nd deadline approaches for the lifting of the ceiling on US debt issuance.  Obama's walk out and the action by Moody's which puts the US on a "downgrade watch" have heightened the alarm among political and economic pundits that there is a significant chance that the US will default on servicing its debt obligations. Some in politics make the comparison with Greece, which most observers think will soon default, but this is not a good comparison at all, as Greece's default would be an involuntary default (as they really can't borrow to pay the interest on their debt), whereas a US default would be a voluntary default (which is caused by the unwillingness to raise the debt ceiling).

As many have already commented, the raising of the current limit of $14.294 trillion, which has already effectively occurred as the Treasury has been doing by borrowing from funds in its control to keep government going (see the debt clock if you don't believe me), involves a balancing act based on commitments that both republican and democratic parties made to their electorates. Grover Norquist though, has the republican signatories to his "tax pledge" over a barrel - he made most (235 Representatives and  41 Senators) of the GOP elected representatives sign a pledge that states that "I will oppose any and all efforts to increase the marginal income tax rate for individuals and business" and "oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates". Clearly this really boxes in the GOP - it cannot vote to get rid of wasteful subsidies, nor can it vote for an increase in the taxes for the uber-rich.  So that is why this looks like it will become a full blown US crisis pretty soon.

How can you continue to support a no tax increase policy when there are obviously very good reasons to increase taxes with reduced government spending? Your hardline position does not seem to be in the best interest of this nation and the majority of its people.
(July 13, 2011 10:38 AM)
A. Grover Norquist :
Thank you for your comments.
You are wrong.
(July 13, 2011 1:13 PM )

Read more: http://www.atr.org/highlights-washington-post-chat-grover-norquist-a6337#ixzz1S4k7roZw

When asked recently whether elected representatives should continue to follow the pledge not to raise taxes if it is against the interest of the country, his response was "Thank you for your comments. You are wrong". He is basically telling elected representatives that if they vote for anything that raises taxes ( - and his interpretation of raising taxes involves even eliminating subsidies) that he will campaign against them when they are next up for election. Now, whether you think that Norquist is a lunatic or a visionary, the consequences of a default would undoubtedly raise interest rates significantly and would also likely have far-reaching consequences.

Like what?  Well as Ben Bernanke made clear on Capitol Hill yesterday, the first thing would be massive cuts in federal expenditures - military ( - although some republicans have already passed legislation detailing that troops should get paid first), social security and pretty much all federal government expenditures across the board. That would immediately cause a "Greek-style" recession as austerity reverberates through the economy with federal government workers being laid off or suffering large pay cuts. Bernanke also said a  default would "throw shock waves through the entire global financial system", meaning that US government bonds and T-bills would suddenly become much less attractive to foreign investors and would immediately be downgraded by the rating agencies. That means a large increase in interest rates as foreigners dump their holdings of US bonds and swap them for something else. That increase in interest rates would also be apparent in the US, which would automatically reverse the Federal Reserve's current monetary policy, making loans for housing and anything else much more expensive. That would hurt the housing market, and therefore consumers, and would also hurt any US business looking for a loan for business expansion.

So how bad could it get? Well the US is also the world's trading currency and most sought after currency in other parts of the world - so that would also be under threat, leading to a giant boost for the euro, perhaps a boost that it could really do with right now after all the bad news in the last few months. So the stakes are extremely high, and although there is always brinkmanship involved in cutting these political deals, in my view the chances are around 50:50 that a default will happen.

As I've already argued, apart from a few republicans who haven't signed up to Norquist's pledge, the rest are completely boxed in, and unless they all decide to go against the pledge they signed, I don't see any way out for them. The alternative is that democrats give way and agree to massive cuts - and of course that hurts their constituency the most, so they will resist this at all costs. The republicans have already suggested a short-term stop-gap, whereby "three times between now and the 2012 presidential election, the White House would send a request to Congress for a debt-limit increase of $700bn or $900bn. Congress would each time vote to reject the request and the president would then veto the denial" (see the FT on this). In other words the debt limit gets lifted by default as the proposed increase is denied and passed by the President vetoing the denial.  In other words the GOP want to be seen to vote against lifting the limit so that they don't break their pledge - but once again this is just "kicking the can down the road" as what happens after the 2012 presidential election?

How can you continue to support a no tax increase policy when there are obviously very good reasons to increase taxe reduced government spending? Your hardline position does not seem to be in the best interest of this nation and the majority of its people.
(July 13, 2011 10:38 AM)
A. Grover Norquist :
Thank you for your comments.
You are wrong.


Read more: http://www.atr.org/highlights-washington-post-chat-grover-norquist-a6337#ixzz1S4jVWvIN

How can you continue to support a no tax increase policy when there are obviously very good reasons to increase taxes with reduced government spending? Your hardline position does not seem to be in the best interest of this nation and the majority