Tick, tick. August 2nd is the Debt Limit Armageddon. Or Not.

America's debt ceiling
Special topics in calamity economics

Jun 27th 2011, 15:24 by R.A. | WASHINGTON

OVER the past week, there has been an uptick in fretting over the outcome of the debt-ceiling negotiations. House Republican Eric Cantor bailed on the negotiations, and a spate of public sniping broke out, generating fears that Republicans and Democrats are farther from an agreement than had been imagined. Bargaining has now been kicked upstairs to the president, who will meet with Senate leaders to try and hash out a deal.

In the current issue of The Economist, there is a rather disheartening look at just what might happen if talks fail. The distressing answer is that no one really knows, but that financial market havoc is almost sure to result. In a May post here at Free exchange, a colleague wrote that in the event of a temporary breach of the limit, the government would likely opt for immediate, massive cuts in order to prevent an outright default. Quite apart from the financial market implications, that would represent a hugely contractionary force on the economy, probably sufficient to send it back into recession. And in the case of actual default? Keep in mind that investors around the world have gobbled up American debt in recent years as a safeguard against trouble elsewhere. If that rock of safety suddenly became vulnerable, well, September of 2008 would probably look like a picnic in comparison.

My operating assumption has long been that the debt ceiling will be raised. The potential cost of a failure to do so is just too large for either party to tolerate. And despite the recent ructions, I still think that an increase in the ceiling is likely. But I think it's fair to say that the odds of some kind of "default", while quite low, have risen a bit.

This could potentially be a problem. Markets try to prepare for trouble. If there's a chance of bad times ahead, market participants will take precautions, just in case. They may move money to safer assets, increase cash holdings, curtail marginal investments, put off hiring, and so on. Do you see the problem? These sensible measures are themselves bad for the economy. Now, the probability of an actual default isn't very high. But the cost of default is catastrophic. So even if the odds of default shift from very small to slightly less small—from say 2% to 5%—that shift represents a substantial increase in the potential economic downside looking forward. And that, in turn, could lead to greater precautionary measures from banks, businesses, and households.

Because failure to raise the debt ceiling would be so nasty, that very possibility could cause serious economic damage even if the odds of an actual default never approach 50%. This, once again, is why Congress should tread extremely cautiously. Its only responsible course of action is to pass an increase in the debt ceiling without any further delay, and certainly without any further dramatics.

It has been all over the media that the Dems and Repubs are at loggerheads over raising our debt ceiling. If that doesn't happen, the country will default on its obligations and the economy of the U.S. and the world will collapse. We have talked about this for some time on A2K in various threads. I thought I would try to consolidate the discussion.

Why Obama May Stall the Debt Talks
Going slow is in the president's interest.


President Obama speaks about fiscal policy at George Washington University on April 13, 2011.

By Marc Ambinder
Updated: June 28, 2011 | 1:16 p.m.
June 28, 2011 | 6:00 a.m.

The two principals in the debt-ceiling talks, President Obama and House Speaker John Boehner, began talking on Monday with the same deadline: August 2, when the federal government will default on its debt. But Obama’s clock is running slower. And that means his leverage may ultimately be greater if he waits for several weeks before making a deal.

Obama’s political apogee will be in late July, when, if there’s no deal, the bond market will begin to panic, leading interest rates to rise and the stock market to fall. That’s when the public will begin to understand what happens when the U.S. can’t make its payments to creditors. That’s when the president can use his bully pulpit to call for an adult conversation.

That’s why Republicans want the White House to focus on vote counts right now. What combination of policies will exceed the necessary threshold for passage in the House and the Senate? Boehner is willing to concede that a debt-ceiling deal based on Rep. Paul Ryan’s budget plan may not get 218 votes. And Republicans have already conceded that they’re willing to cut significantly from defense appropriations to get them.

What Boehner would like the White House to concede early is that its effort to, say, end oil-company subsidies, raise taxes on individuals making $500,000 and up, or curtail sugar and ethanol tax breaks, would also fall short. If the vote were tomorrow, he’d probably get a higher spending-cut to deficit-trigger ratio from Democrats, too. He’d get close to $2 trillion in real cuts over 10 years.

Boehner's bottom line: real spending cuts that exceed the amount by which the debt limit is raised looks reasonable today. Since a large minority of his conference does not believe that the August 2 date is real, Boehner's aides insist that it's foolhardy to think they are any more likely to accept revenue raisers (including getting rid of tax breaks) as the weeks go by.

But Obama knows that vote counts in the absence of the crucible of crisis will differ when Wall Street, the U.S. Chamber of Commerce, and other traditionally Republican interests begin to nervously walk lawmakers out of their partisan garrisons.

And he’s betting that Republicans, having learned that his team is on nimble feet when it plays close to the edge of the cliff, will concede more up front than they did in December, when only the threat of a government shutdown (darn it, the Smithsonian would be closed!) loomed as the existential sword of Damocles. The longer Obama waits, the more Republicans will privately panic, knowing that their leverage decreases steadily as the weeks go by -- and exponentially at the turn of August.

Republicans have succeeded in turning Washington’s orientation toward spending, but they probably aren’t willing to blow that credibility if the endgame comes down to either a government default or an end to subsidies. That’s why, in private, Republicans want the discussion to begin with the president getting inside Boehner’s head: What can the White House offer to allow Boehner to get enough of his Republicans to go along, anticipating that Democrats will need at least a third of their caucus or more to reach the threshold? After last year’s election, overconfident Republicans assumed that Obama would not be able to broker any deal, with demoralized Democrats retrenched and the public having markedly signaled their distaste with Washington. They were wrong then and they’re trying to be more careful now.

1) Is August 2nd a drop dead date?

3) But the world's faith in the U.S. economy will be harmed?

4) What is the difference between national debt and national deficit?

realjohnboy wrote:

3) But the world's faith in the U.S. economy will be harmed?

Not in the economy, but in the safety of US debt. At the moment, bond markets are scrounging to lend to the US government at historically minuscule yields. They are doing this because they perceive US debt as essentially risk-free. As soon as the US defaults on its debt, bond markets will know their perception has been wrong, and will likely demand substantially higher interest rates to compensate for the risk. This, in turn, will be toxic for the US economy.

Why spending cuts, but no tax increases - especially on the wealthy?

If interest rates in general zoom up from 4-5% to 10%, bonds are going to drop like a rock.

That said, the market is clearly not worried yet. Bond prices are remarkably stable given that both the US and Europe can see financial armageddon on the horizon.