The Bonds of August

An Historical Analogy applied to today’s debt ceiling crisis, with apologies to Barbara Tuchman

Discerning readers of history (so that excludes a number of people) will recall that in Tuchman’s magisterial account of how the world went to war in August 1914, she identified several factors that accounted for why the leaders of the great powers each felt victory would be painless assured. First, they thought that the war would be quick; “Home before the leaves fall”, as Kaiser Wilhelm predicted. Second, they broadly misunderstood the economic implications of the conflict, believing free trade would prevent an expansion of the conflict to continent-wide proportions. Third, military leaders failed to consider the political implications of military plans, such as the German violation of Belgian neutrality.

The result was a costly and prolonged war that no leader sought, or even contemplated, but were pushed into exactly because of their mistaken beliefs.

I think we could very much be in for a repeat of this experience. Even if there are extraordinary measures are implemented which extend the X-date beyond August 2nd, the very fact that the Republicans have no viable plan, given the veto held by the Tea Party component [0], for achieving some sort of compromise indicates that we are inexorably moving to some sort of crisis. Consider the following:

  • Certain individuals believe the debt default would be temporary (or “technical”), lasting until the politicians come to their senses (Pawlenty, Ryan) [1] or can be avoided by selectively defaulting on only non-debt payments (Bachmann, Gohmert) [2]
  • Certain individuals think the effects of the default would be short lived and minimal.
  • Certain individuals think that the rest of the world (including holders of US Treasurys, like PBoC) will not react to a default, and the policy paralysis evidenced by this event. [3]

My analogy is not completely apt in one important sense. The delusions are almost completely held on one side. As long as these delusional individuals hold veto power in the policy process, we are doomed to some sort of event; perhaps it will take a EESA redux — with trillions of dollars of equity value wiped out, and municipal bonds being eviscerated [4] — to make them realize that this is not a game.

By the way, even if the Administration is able to extend funding capacity beyond August 2nd, the one thing those of who have studied currency crises in emerging markets know is that — given rational expectations — the crisis typically occurs before the exhaustion of reserves (Krugman, P. (1979) “A model of balance of payments crises”, JMCB 11: 311-325.) There is some evidence of this wariness already. [5] Of course, as international finance economists we typically thought of first-generation currency crises as a problem restricted to emerging markets and less developed economies. Little did Jeff Frieden and I know that when we entitled the first chapter of our forthcoming book, Lost Decades, “Welcome to Argentina”, how apt that title would become in describing policy making as well as policy problems. That policy paralysis due to ideology is something financial market participants have also noted.

For those who think a 4 to 1 ratio of spending cuts to tax increases is still too much tax increase, and believe all adjustment can be done by spending cuts alone, I bring their attention to the following graph of spending and revenues.

Figure 1: Federal current expenditures, line 20, BEA Table 3.2 (red) and sum of Federal tax receipts and social program contributions, lines 2 and 11, BEA Table 3.2, both divided by GDP. All raw figures in billions of $, SAAR. NBER defined recession dates shaded gray. Dashed lines at 2001Q1 and 2009Q1. Source: BEA, 2011Q1 3rd release, NBER, and author’s calculations.So what will the impact of a default be? The IMF reminds us that, just like WW I did not remain contained to a few countries, the fallout from a US default is likely to global in nature (from Reuters):

An IMF official, briefing reporters by telephone, said that if the United States’ AAA debt rating — regarded as the gold standard for creditworthiness — was downgraded it could be “extremely damaging” for the U.S. and world economy.

The IMF official said that, since such a downgrade would be precedent-setting, it was impossible to predict with certainty the impact, but it would certainly drive interest rates up.

While underlining the urgency of reaching a debt-reducing agreement, the IMF also cautioned that an “excessively large upfront fiscal adjustment” should be avoided because that would further dampen domestic demand and slow growth.

“With a still-wide output gap and downside risks to the outlook, especially potential spillovers from European financial markets, directors called for a cautious approach to unwinding macroeconomic support,” the IMF said.

For another analogy, see Jeff Frankel’s interpretation of the game now going on.

Finally, a bad omen (USAToday):

“The markets are pricing in a strong likelihood of no default and no government shutdown,” says Don Luskin, chief investment officer at TrendMacro.

This is the same Don Luskin who wrote on September 18, 2008, that “we’re on the brink not of recession, but of accelerating prosperity.” In the next quarter, real GDP fell 6.74% (SAAR). I’ll take the “Don Luskin indicator” to suggest we are hurtling toward a very serious situation.

This post originally appeared at Econbrowser and is reproduced here with permission.