Putting Down the Debt Ceiling Sword

Posted: Oct 16, 2013 1:36 PM
Putting Down the Debt Ceiling Sword
The United States has never missed a payment due to a failure to increase the debt ceiling in its modern history. We've come close - multiple times - and the fear has swirled inside the beltway as the X-date that the federal government will be unable to make payments approaches.

Markets have been resilient in the face of an unprecedented financial situation. As Allie Jones wrote for The Atlantic Wire:

The stock market has been moving up and down since last week, as Congress moves closer to and then further away from a debt limit deal. On Friday, the markets rebounded from near one-month lows; on Monday, the Dow Jones fell back down again. But the global financial system is not in crisis — yet. Probably because Wall Street doesn't actually think Congress will allow default.

Using the debt ceiling is almost a tradition for members of Congress. Dozens of times, it's been used by minority parties as leverage against the executive branch in order to pass legislation that the President is not amenable to. The obvious downside to using the debt ceiling as leverage is the risk of default and global financial crisis. However, some economists have made the case that use of the debt ceiling as leverage in and of itself causes financial instability and could be leading to unnecessary economic struggles.

After the last major debt ceiling negotiation in 2011, ratings agency Standard & Poor's downgraded the United States' credit rating from AAA to AA+. An S&P official told the Wall Street Journal that S&P's downgrade reflected the fact that Congress' actions "involved a level of brinksmanship greater than what we had expected earlier in the year."

The S&P downgrade report "reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011."

Stan Vueger, an economist and resident scholar at the American Enterprise Institute, says that even aside from the direct effects of the S&P downgrade, there were negative macroeconomic impacts from debt ceiling brinksmanship. "Consumer confidence dropped significantly among that period, to levels seen at 9/11," Vueger tells Townhall. "[And] the broader impact of the level of uncertainty stranding decisionmakers in the private sector. The best-known paper on this is by Nate Bloom and Steve Davis of Standord and Chicago. According to their measure of uncertainty, the level of uncertainty right before the [2011] debt ceiling increase was the highest ever recorded... there's a reasonably broad literature at this point on how that uncertainty spike harms all kinds of outcomes, from GDP to investment to employment. That kind of brinksmanship does do real damage."

Michael Strain, an economist and Vueger's colleague at AEI, agrees. "If you put uncertainty aside and just take consumer confidence. Consumer confidence fell to the level that it hit when Lehman collapsed [in 2008]."

The S&P downgrade itself, however, took into account the fact that the fiscal consolidation legislation that emerged out of the 2011 debt ceiling negotiations was a positive development - but that the downgrade happened in spite of that positive development, not because of it.

The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.

S&P downgraded the U.S. credit rating for two reasons: policymaking in Washington has become more uncertain due to polarization, and Congress has not committed strongly enough to long-term debt stabilization.

"Whatever uncertainty there is, it's created by both sides of the aisle," Veronique De Rugy, economist at the Mercatus Center, tells Townhall. "S&P made it extremely clear what they needed to see, and that was a path that would be credible and would lead to a $4 trillion reduction in debt over the next ten years... that deal did not produce this."

"If we think that uncertainty is creating negative consequences, it's not just the Republicans... to the extent that we want to say that there's uncertainty, and it's created by the debate, the blame has to be on both sides," De Rugy says.

This time around, uncertainty has increased, consumer confidence has dipped, but markets have been largely resilient. President Obama oddly attempted to scare the markets in the lead-up to what looks like an inevitable deal. Ratings agency Fitch put the U.S. on "negative watch" this week, however, primarily because "the U.S. authorities have not raised the federal debt ceiling in a timely manner before the Treasury exhausts extraordinary measures."

To a large extent, these are largely subjective judgments from the ratings agencies. (A reminder: credit ratings agencies have been very, very wrong in their subjective judgments.) The ratings agencies have a large amount of sway when it comes to macroeconomic effects, and their subjective judgments do carry a lot of weight.

Brinksmanship over the debt ceiling has been a common feature of the American political system. We're about to see another late-in-the-game resolution. In 2011, Republican intransigence resulted in the Budget Control Act, which put America's medium-term debt on sustainable footing, which Fitch actually praised in their negative rating watch:

Fitch's medium-term fiscal projections imply federal and general government (which includes states and local governments) gross debt stabilising next year and over the remainder of the decade at around 72% and 104% of GDP, respectively. This is below the 80% and 110% thresholds that Fitch previously identified as being inconsistent with the U.S. retaining its 'AAA' status.

This year, there will likely be no concessions from the governing party to the minority party, and the economic effects will likely be small. Use of the debt ceiling as leverage has a long history in Congress. It would be unprecedented for the current minority party to pledge not to use the debt ceiling as leverage in the future.

Nonetheless, that's what Republicans should do.

The last few years in which Republicans have exploited their minority leverage to try to pass their policy preferences have come during unique economic times. We've been sluggishly recovering from the 2008 financial crisis. In 2011, the European Union was melting down. This year, the economy has been resilient in the face of sequestration, which was projected to make a medium-sized hit in economic growth. The economic impact of mere negotiations over the debt ceiling may not be large, but they're likely unnecessary - even given the potential long-term benefits of BCA-type budget deals that might be achieved.

Markets have continued to believe this time around that there would be a last-minute deal to avert hitting the debt ceiling. Republicans will probably come out of this round of negotiations having gone through a two-week government shutdown and a default threat with nothing to show for it. There are better ways to govern, and the Republicans would be wise to go those routes.

It's time for Republicans to put down the debt ceiling sword, recognize the difficulty of trying to achieve their policy priorities when they control one quarter of the levers of governance, and focus on the marginal improvements to the U.S that their governing position can actually achieve. A very favorable 2014 Senate map would have awaited the GOP in the absence of this crisis. It still waits.

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