Tuesday, April 5, 2011

Debt Ceiling

I've been away from blogging for a long time. This will almost certainly continue. Some projects have been consuming my free time - work, CFA, taxes, investments, my album, some other stuff TBA - so I apologize. But last night, someone asked this, so I figured I'd post my response:

"Hey Trevor, I have a question:
They don't really say what the 'negative consequences' will be of hitting the debt ceiling (in the next month ish).
Higher interest rates = bad. Collapse of the US government and stock markets? What impacts will we see in daily life?"

Firstly, I should point out that the debt ceiling will be raised, almost guaranteed. I'll come back to this. Let's pretend it isn't. Projecting the consequences of this is like projecting what happens if a natural disaster happens or a WMD goes off - you can do your best, but there's enough chaos going on that there are bound to be unanticipated issues. That said, here's a stab at it:

It means the US will not be able to borrow more money. Think about what the US funds - Social Security, Medicare, the Military, implicit funding of states (which gets spent on infrastructure, medicaid, education, prisons, police/firefighters, etc) and cut all of it in half overnight. There's a decent chance we'd default on the debt because not paying China is politically easier than not paying Grandma's social security (though the consequences of not paying China would probably be way more damaging to Grandma in the long run anyway), though interest payments are only 10% of the budget so you'd still need to make massive cuts. A debt default would impair the economy for a long time because of the impact on interest rates. You'd probably also see a lot of states increase taxes significantly as the Federal government cuts back on aid to states.

I wonder if, in that scenario, the Fed would step in and start printing money to pay off debt - basically, causing massive inflation to solve the problem because it's the only thing that doesn't require congressional approval.

Thus, a lot of people would suffer, taxes would go up, you'd probably see inflation and the economy would not take it well. You know I think the government spends too much and want to see massive spending cuts, but this is because of a long term unsustainable budget structure, not an acute emergency in government repayment credibility (which would spike interest rates - we're not seeing that). These adjustments can't happen in large unexpected shocks - people need time to prepare and to understand what the policy changes mean so that they can be ready, and also so Congress can fix its screwups before they happen (as has been happening with a number of the provisions in Obamacare - the 1099 shuffle, the doc fix, etc - and Dodd-Frank - interchange, mortgage writing requirements, etc - to name two recent examples).

Anyway, all of that said, the debt ceiling will be raised because everyone understands we don't have a choice. It's political theater. It really is unbelievable, though, that in a government with a 1.4 trillion dollar deficit and a budget that's 3.5 trillion, Republicans (the so-called "spending cutters") are only targeting a 61 billion dollar spending cut while using the spending cuts opportunity to target completely unrelated social issues... and the Democrats (The "one marshmallow eater party") are crying foul and claiming we can only afford to cut 30 billion. The tone of debate among both parties is really discouraging.

A friend who worked at the DOE once told me that they have to prepare their budget 3 years in advance - and it's always "use it or lose it". Thus, they all got new computers and office furniture every year. Changing discretionary budgeting procedures to make them nearer term, more flexible and reduce the incentives to constantly ramp up spending would probably eliminate more discretionary spending than anyone currently thinks is possible. Of course, discretionary spending is only like 12% of the budget, but still, a 3% or 4% budget cut is significantly more than anyone's discussed so far.

(reference for the one marshmallow eater party: www.themoneyillusion.com/?p=9359)

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