Today marks a critical day in the battle over the 2011 budget…the fiscal year we’re already halfway through. Though the federal government has been kept alive via a series of Continuing Resolutions, this Friday will be the end of the easy stuff. At the end of the day on Friday, the federal government will hit the debt ceiling of $14.294 trillion (about $46,000 for each resident of the US). Without an increase in that debt ceiling, the federal government will be forced to choose between two options:
- Default on the debt
- Shut down major portions of the government
I’ll discuss both of these shortly, but first…why is today the deadline when we are still solvent until Friday? Because the House voted in new rules this year to have bills available for public viewing 72 hours prior to the vote. So if we don’t have a deal today, the options are violating that rule or choosing between the two above options at the end of the day on Friday. It’s possible to stretch this out until Thursday, since a “shutdown” over the weekend will have minimal impact, but that’s the absolute end of the line without violating the House rule.
So let’s look at the two options.
Defaulting on the debt would have a disastrous effect on the US economy. Assuming the US would be able to issue any additional debt in the future, the interest rates for those bonds would be substantially higher than they have been historically. For the past century, there was no safer place to park money than in United States debt. This certainty translates into lower interest rates, because the reduced perceived risk leads lenders to feel no need for a risk premium (in essence, a higher rate includes a virtual insurance policy). If a default occurs, it will be at least several generations before that risk premium will disappear.
That higher perceived risk will also translate into a much weaker dollar, since the dollar will stop being used as the default (sorry) global currency. Just as the US debt has historically been considered the safest place to park money, so, too, have dollars themselves. The European Union, who has taken great pains to avoid any defaults of their own debt, will most likely become the economy of choice for safe parking, which would result in a dramatically stronger euro.
Sadly, Rand Paul has been saber-rattling about default, even though it’s unclear how serious he is about it. While such posturing may be good politics, it’s terrible economics. It’s akin to going to the loan officer and loudly announcing “Yeah, I might not bother paying you back,” before even asking for the loan. While I wholeheartedly agree that the debt is a substantial problem and needs to be addressed without delay, it needs to be done with care and maturity. Paul is showing neither.
Shutting down the government is barely a better option than default. Presuming that such a shutdown lasts only a few weeks, the medium-term costs are likely to be significantly higher than simply maintaining the status quo. This arises because of the costs of breaching the multitude of contracts in which the government has already engaged. A shutdown of several months might recoup those costs, but the repercussions through the economy would be catastrophic. Government activity represents approximately 20% of the GDP. For comparison, the frothy real estate market and its ancillary industries (e.g., construction), represented just under 5% of GDP in 2007 and 2008. In other words, the impact can be expected to be about four times as great as the impact of the housing bubble popping.
Of course, it’s not like the entire government needs to shut down in order to maintain solvency, so the amount of GDP impact will almost certainly be less than 20%. For the entire 2011 fiscal year, interest on the national debt represents only $250 billion, compared to the revenues of $2.23 trillion. That’s only about 11% of revenues devoted to servicing the debt. The remaining 89% of revenues can still be spent, which would mean reducing spending by “only” 43%. So it’s not 20% of GDP; it’s 9%, which is still 1.8 times the amount that housing represented in the economy.
In other words, the impact is huge.
So, given the three choices of raising the debt ceiling, defaulting on the debt, and cutting the federal government expenditures by 43%, the first option has the lowest impact on the economy, by far.
Republicans are caught in a tough spot right now. Many were elected on the promise of cutting government spending by $100 billion from the 2010 budget (which would be $3.4 trillion). This was first walked back to a $100 billion reduction from Obama’s 2011 budget request (which would be $3.7 trillion, or a net increase from 2010 of $200 billion). But even that far easier number seems unachievable, in light of a Senate and White House still controlled by Democrats. What seems agreeable to many on both sides of the aisle is a cut of a little over $30* billion from Obama’s original budget proposal, which ultimately nets about $270 billion over 2010.
But can the House Republican leaders convince the Tea Party that a net increase of $270 billion over 2010 is acceptable? It’s hard to imagine that it is, given the chants of “cut it or shut it” at the rallys. I fear that the overall impact of a shutdown is under-appreciated by those with a more ideological bent.
Paul Ryan isn’t exactly helping by talking big (four trillion dollars in cuts), while avoiding the small-print reality (it’s over ten years, almost entirely back loaded, and his proposal makes a ton of barely credible assumptions).
That’s not to say that we shouldn’t be addressing the national debt; we should. But the responsible way to do it is by drawing it down when the economy is healthy, and to do so in a way that is relatively gentle and predictable. Ideological ranting and chanting does nothing to help us achieve that goal.
*In an earlier version of this article, the number was erroneously listed as $300 billion, not $30 billion.
- What to Watch For in the Budget Showdown (politicalwire.com)
- Looming Gov’t Shutdown Just Part of Spending Fight (politics.blogs.foxnews.com)
- Deal Needed To Avoid Spending Train Wreck, Government Shutdown (huffingtonpost.com)
- Uncertainty might be biggest shutdown cost (msnbc.msn.com)
- U.S. Treasury Would Sell Debt in Shutdown, Official Says (businessweek.com)
- Deal to avert government shutdown closer (marketwatch.com)