IMO, over coming days, the participants in the negotiations need to set aside their maximum positions, recognize the needs of all the parties, and focus on areas where agreement can be reached. The focus should be on making offers that have a realistic chance of being viewed as acceptable by all the parties. That means setting aside tax changes. It means postponing credible entitlement reform. It means focusing on smaller spending reductions and disproportionately in the discretionary spending area. That is not an optimal or credible fiscal consolidation approach, but because so much time has been exhausted on a badly-designed negotiating process that allowed each side to begin from its maximum position, it is increasingly a matter of necessity. Personally, I would prefer a credible fiscal consolidation path, but when the choice is between something less or fiscal crisis, the former outcome is the better one. Otherwise, more time will be consumed on process and the deadline will draw closer.
Unfortunately, some elements are seeking to preclude any kind of deal. For example, yesterday one talk show host hailed the prospect of a failure to raise the debt ceiling as a new 'Independence Day' of sorts. He
declared:
August 2nd will be the new July 4th, this time a day of liberation. Liberation and freedom from massive government spending that has put us and our children in a continuous debt.
That statement is breathtaking in its ignorance. It shows a total lack of comprehension as to the impact of the federal government's having to instantly cut its cash outflows by some 40%. It shows a complete lack of understanding of what such cuts as a share of GDP would mean.
Immediately eliminating that deficit would result in a shock that would be twice the magnitude of the recent severe recession from which the U.S. emerged, if only that spending were involved. The shock would be greater, on account of a multiplier, rise in public and private cost of capital, and financial sector distress.
An effort to ration spending that would also give priority to servicing debt would also adopt the rosy assumption that debt service would essentially consist of making interest payments. Under such an assumption, there would be no risk of default. That may not be the case. The increased risk associated with U.S. debt would probably lead to some share of the debt not being rolled over. That could then mean principal on maturing debt would have to be repaid. Secretary of Treasury Geithner noted in a letter to Senator DeMint that about $500 billion in Treasury securities would mature in August. If one considers some share of principal having to be paid, then the pool of funds for remaining obligations (Medicare, Medicaid, Social Security, Defense, and myriad discretionary expenditures) would be even smaller.
There is also the problem of mismatches between monthly receipts (revenue) and monthly expenditures/maturing debt. Monthly revenue and monthly expenditures/maturing debt could be quite divergent. That could exacerbate an already difficult management process.
In the end, failure to raise the debt ceiling would be anything but a "day of liberation." It would be a day the nation's policy makers demonstrated an inability to make necessary choices. It would be a day that showed that the U.S. is a much riskier country than its current AAA rating implies. It would be a day that the U.S. lost significant leadership credibility, and that loss of credibility would extend well beyond fiscal matters.
Afterward, even when the issue would be resolved, the nation would be left with higher interest rates on account of the new risk environment. With domestic nonfinancial debt of $36.333 trillion, the nation as a whole would pay just over $180 billion per year in extra interest were rates to rise 50 basis points and about $363 billion in extra interest were rates to rise 100 basis points (some timing issues, but that debt continues to increase at a multiple of GDP). That would be equivalent to 1.2% and 2.4% of 2011 Q1 GDP respectively. Those added interest charges would lead to a lower long-term economic growth rate. The nation's fiscal position would be adversely impacted (slower revenue growth and higher debt service costs). Worst of all, this outcome would have been wholly avoidable. The crisis and its aftermath would have been completely self-inflicted.
