Our Current Impasse:
Raising the debt ceiling has become inexorably linked with debt & deficit reduction plans. Until last week, the market’s consensus was that – despite the divided rhetoric from the Democrats and Republicans in Congress – the debt ceiling would ultimately get raised and the US economic recovery could continue without interference. For example, the world markets reacted enthusiastically to news of bipartisan plans of reconciliation around the so called “Gang-of-Six” proposal: an outgrowth from the President’s Commission on Fiscal Responsibility and Reform.
Any hopes for a popular bi-partisan resolution to this crisis were premature. The President offered several versions of a “Grand Bargain” – combining entitlement reform with revenue increases with the expressed goal of cutting the debt by $4 trillion dollars over the next decade – but the Republican negotiators (most recently, House Speaker John Boehner – but Senator Mitch McConnell and Representative Eric Cantor have also had significant input in these discussions) have not been able to generate agreement with their caucus. Many of the newly elected Republicans in the House of Representatives campaigned on a platform of a significantly reduced government, reduced spending and lowered taxes. Compromise is not part of their perceived mandate.
Most recently, the Republican House leadership put forth a new plan (“Cut, Cap and Balance”), with a two-step plan on Debt Ceiling increases and few concessions to Democrats, does not currently carry the votes necessary to pass in the Senate and carries threat of a Presidential veto. In reaction, Senate Democrats put together a smaller bill, attached to a limited amount of spending cuts ($2.7 Trillion) that would to increase the debt ceiling until 2012 and forego any new revenues.
Let us ignore the actual political positions of the Democratic and Republican bills. Let us consider only the efficacy of the negotiating tactics. In the face of great risks and an electorate that, according to polls, strongly prefers a compromise, the threats on both sides for withdrawing completely from the negotiations have been high. Republicans have walked away from the negotiating table several times during this process. The President has threatened several positions – including the current “Cut, Cap And Balance” bills with Presidential veto. For the moment, the political brinksmanship seems to be working better for the Republicans. The latest Democratic bill contains only spending cuts in return for raising the debt ceiling for an extended period (which, under most administrations, used to be a given rather than a point of concession).
To use an analogy, it’s like playing “Chicken”. Two cars are driving towards each other on a single lane highway. An effective way to get the other driver to swerve off the road is to convince your opponent that you will not swerve under any condition. (In game theory, this is called signaling pre-commitment.) This tactic is being used effectively today in Congress.
There are three negative outcomes to this debt-ceiling crisis: default, downgrade and deterioration.
The majority of politicians continue to work on avoiding a full scale default. However, the reality is a little more complex than simply Republicans vs. Democrats. The current Republican plan is being attacked from the far right of the party for being too undemanding; and some representatives favor a full default as the ultimate enforcement of immediate spending cuts. The liberal wing of the Democratic party has attacked the President’s Grand Bargain for conceding too much. Mitch McConnell recently promoted “last-choice” plan to cede the debt ceiling authority to the President through a creative use of veto power, and symbolic (but meaningless) congressional procedure. McConnell’s plan was not well received by the Republicans who originally promoted this debate to attach spending cuts to debt ceiling increases. Still, the majority would prefer to avoid default – despite the political pressure. A full scale default, the most catastrophic outcome, is the still least likely scenario.
A downgrade on US Debt from one, or more, of the ratings agencies is more likely. As of July 26, analysts suggest that the inability of Congress to generate a large deficit reduction bill places the odds for an official rating agency downgrade at 50%/50%. The impact of a downgrade would still be severe, but it is difficult to quantify exactly how painful it would be.
Consider this: Modern Portfolio Theory and the Capital Asset Pricing Model - two Nobel Prize winning systems – are the basis for modern finance. In practical application, economists, market analysts or other financial professionals base their findings compared to a number of key assumptions. One of the primary assumptions is the selection of a “Risk-Free” asset. You may wonder, what do industry professionals select as “Risk-Free” asset? It is the US 3 Month Treasury Bill. If the US loses its AAA Rating, it will require a rewrite all the books on finance. It is impossible to predict the full impact of rewriting the value on such a fundamental asset class.
Perhaps you feel that this example is a little abstract and does not convey enough of a tangible consequence. Consider this example: institutional investors typically have Investment Policy Statements which act as guidelines for their behavior. The Investment Policy Statements of several large institutions, representing many billions of dollars, specify the amount of their bonds and fixed income which must be AAA Rated. If US Debt is downgraded, then these institutions may be forced to sell their US treasury debt at the same time. Increased Supply and decreased demand would put significant downward pressure on the prices of US Debt.
Finally, let us consider the last negative consequence: deterioration. Specifically, we are considering the deterioration of the perceived quality of US Debt – regardless of the rating agencies’ official opinions. Sadly, this deterioration is likely and, quite possibly, already evident. The current impasse, after all, does not represent the hypothetical musings of an economics professor at a blackboard. Foreign investors in US debt and currency have watched this debate with varying degrees of alarm as the unthinkable becomes, if not probable, quite possible. Long term US Treasury Bond holders may require higher yields to compensate them for threats of non-payment or insolvency.
Consider a scenario in which Republicans and Democrats reach a deal, immediately raise the debt ceiling, and set up a long term plan to reduce the debt by the $4 Trillion dollars requested by the rating agencies to preserve the AAA Rating. (It does not matter if the deficit reduction is based exclusively in spending cuts or if tax increases round out the plan.) The most up-to-date data states that 53% of US Treasury debt is owned by foreign investors. We find it difficult to believe that foreign investors are going to consider US Treasuries as the safe and secure investment it once was, given the recent drama in Congress. Furthermore, high stakes tactics may yield the best short-term results for the most aggressive negotiators, but the consequence may be an escalation of hyper-partisan behavior and greater dysfunction. In short, we may get through this crisis with our credit rating intact, but the high-stakes game of brinkmanship has already damaged our national credibility and our ability to work co-operatively in Congress.