Five Reasons to Fear the Debt Ceiling

Thanks; Blomberg / By the Editors October 06, 2013 6:00 PM
EDT The global economy is facing a bizarre
man-made threat: Radical legislators in the U.S., issuer of the
world’s most trusted currency, think forcing the government to
renege on its obligations would be a good way to shock it into
recognizing the error of its fiscally imprudent ways.
Lest anyone take this notion seriously,
here’s what would happen if that threat were carried out. To keep
spending, the government needs Congress to pass a spending law.
Republicans have already blocked this, resulting in a partial
government shutdown. Now they are threatening the separate and much
more disruptive step of refusing to raise the federal debt ceiling,
currently set at $16.7 trillion. Spending exceeds revenue, so
without permission to borrow more, the government can’t pay its
bills even if a law to allow spending goes through. If the debt
ceiling stays in place, the Treasury will run short of cash soon
after Oct. 17. At that point: 1. Global markets will see the U.S.
government as grossly and dangerously incompetent. Refusing to
raise the debt ceiling is fundamentally different from cutting the
government’s funding. It’s as if Congress were sending the Treasury
two contradictory and legally binding orders — one that requires
it to make hundreds of billions of dollars a month in payments,
another that prevents it from borrowing the money it needs to do
so. Which order is the Treasury supposed to obey? This is the stuff
of absurdist theater. Confidence matters, and this event would
destroy confidence. 2. Forced spending cuts will kill the economic
recovery. Over the course of a year, the Treasury borrows roughly
$1 out of every $5 it spends, so hitting the debt ceiling would
require it to cut outlays by about a fifth — and by much more in
the short term, because flows into and out of the Treasury are
lumpy. Such a severe fiscal squeeze would crush a still-tentative
recovery at a time when widespread unemployment is threatening to
do permanent damage to the country’s productive capacity. 3. The
U.S. government might actually default on its debts. Some in
Congress apparently think that hitting the debt ceiling needn’t
mean missing a payment on the $12 trillion in government bonds
outstanding — an event that markets would call a default, which
could trigger a financial catastrophe (see No. 4). The House of
Representatives has passed legislation to authorize the Treasury to
prioritize such payments. Even if the Senate passed that measure,
which it has refused to do so far, it might not be enough. The
Treasury processes more than 80 million separate payments a month,
using an elderly system that wasn’t designed for debt-ceiling
damage control. Money to bondholders goes through a separate
channel called Fedwire, so some segregation might be possible —
but accidents are all too probable, and a payment could easily go
missing. Markets are aware of the risk: Yields of Treasury bills
maturing in the second part of October are abnormally high,
suggesting that investors are demanding compensation. The cost of
insuring against a U.S. default has almost doubled. 4. A default
could trigger a global crash. Treasury bonds are the foundation of
the U.S. and global financial systems. Their yields serve as
benchmarks for interest rates on mortgages and corporate bonds.
Securities dealers in the U.S. hold some $1.9 trillion in
Treasuries as collateral on loans to hedge funds, banks and other
financial companies. Mutual funds, pension plans and corporations
rely on interest payments from Treasuries to meet their obligations
to investors, retirees and workers. The slightest concern about the
U.S. government’s ability or willingness to pay could prompt
investors to demand a higher return on the bonds and dealers to
toughen the terms on which they accept Treasuries as collateral.
That would abruptly raise the cost of credit for everyone — or
else freeze financial markets altogether. Economists have estimated
that a few missed Treasury-bond payments in 1979, the result of a
brief technical glitch, pushed up interest rates by 0.6 percentage
point and boosted the U.S. government’s borrowing costs by $12
billion a year. It’s hard to overstate the danger. Picture a crisis
in which markets froze and the U.S. government was unable to act
because its own creditworthiness was the cause of the panic. 5. The
government’s fiscal problems will only get worse. It’s true that
U.S. finances are on a troubling long-term trajectory: The
government has promised more to future retirees than taxpayers seem
willing to pay. But in the current impasse, this issue is barely on
the table. Meanwhile, heightened fears among investors will
increase the government’s cost of borrowing. Even a rise of 1
percentage point would increase the government’s costs by $120
billion a year. The longer-term fiscal problem is readily soluble.
Threatening a sovereign default, with all the enormous risks it
entails, is not part of the solution. Arguing otherwise carries
irresponsibility into the realm of insanity.

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