The Outcome of the Debt Ceiling Battle Could Hurt the Economy

If politicians cannot come to an agreement on the debt ceiling, what economic consequences should we expect? And if a deal is reached, does that end our worries?

If Politicians Do Not Reach Agreement
If politicians fail to reach a deal to increase the debt ceiling, there would be a large fall in federal spending. The decline in federal purchases of private sector goods and services would reduce aggregate demand, and this could slow or even reverse the recovery (it could also threaten the delivery of critical services that some people depend upon). In addition, the failure to pay wages to federal workers would disrupt household finances and cause a further decline in demand, as would the failure of the government to pay its bills for the goods and services it has already purchased from the private sector (and it could even threaten some households and businesses with bankruptcy should the problem persist). There may be some room for the Treasury to use accounting tricks to avoid the worst problems, at least for a time, but it is not at all clear how well this would work to insulate the economy from problems and eventually this strategy will come to an end.

That's potentially bad enough, but it's far from the end of the problems that could occur. Failure to raise the debt ceiling could also undermine faith in the safety of US Treasury bills. If we default on bond payments, or appear willing to do so even if it doesn't actually occur and investors lose faith in US Treasury Bills, they will begin demanding higher interest rates to cover the increased perception of risk. This could be very costly. We depend upon the rest of the world to finance our debt at extremely low interest rates. If the willingness of other countries to do this diminishes, then the cost of financing our debt would rise substantially. And that's not all. In addition to increased debt servicing costs, an increase in interest rates would also choke off business investment potentially lowering economic growth, and the consumption of durable goods by households would fall as well. Rising interest rates would also be bad for the housing recovery (such as it is). Thus, failure to reach an agreement could be very costly.

If An Agreement is Reached
But what if an agreement is reached? Does that mean we are worry free?

Not at all, it depends on the nature of the agreement. If the immediate budget cuts are large and poorly targeted, the resulting impact on the economy could threaten the recovery. Those who favor large and immediate cuts argue that the increase in the confidence of investors will more than compensate for the decline in demand, but experience with austerity in Europe substantially undermines this argument. Austerity has made things worse in Europe, not better.

The best outcome of the negotiations over the debt ceiling would be for both sides to agree upon a credible framework for reducing the debt level over time (which must include tax increases). That would give investors the confidence they need that politicians will be able to solve the debt problem without threatening the economic recovery or harming long-run economic growth.

However, due to the past behavior of politicians and the lack of credibility on budget issues, faith in politicians is so low that any agreement about the future will likely be discounted substantially. This means politicians need to show people that they are serious about the debt problem by making large, immediate cuts -- promises are not enough -- and we could be headed for slower growth of output and employment, or even outright declines. Given how slow the recovery is already, and the unemployment crisis that we face, that's a highly undesirable outcome.

A Slower Recovery Has Long-Run Costs
Thus, agreement or not, the recovery is likely to be slower and that could be costly in the long-run as well. As I noted recently, high and extended unemployment can cause permanent effects on economic growth as workers drop out of the labor force, settle for jobs below their capabilities, skills erode, and so on. Thus, anything that threatens to extend the unemployment problem, e.g. a slower recovery arising from the debt ceiling agreement, or lack thereof, can also lower economic growth.

We cannot afford lower economic growth -- the best way to solve the debt problem is to grow our way out of it. A slightly higher growth rate accumulated over a couple of decades makes a huge difference in our ability to pay off the debt. To give some idea of the magnitude of the difference compounding can bring about, a 2.5 percent versus a 2.75 percent growth rate gives a cumulative difference in GDP of $2.4 trillion after just 10 years, $16.5 trillion after 25 years -- more than current GDP -- and an amazing $107.4 trillion after 50 years. At any reasonable tax rate, a difference in GDP of that magnitude makes a huge difference in our budget picture. Thus, any decline in growth due to higher unemployment, higher interest rates, or some other budget related problem will have a substantial impact on our fiscal position going forward.

Lack of Credibility in Congress Makes the Best Solution Unavailable
We have a debt problem that needs to be addressed, but not at the cost of a slower recovery of output and employment, and slower economic growth in the future. The most important thing politicians can do right now is to show that they are capable of making progress on the debt problem without threatening the economy in the process. That requires an agreement on how to proceed over the next few years and longer -- credible promises of debt reduction once the economy can handle it -- rather than draconian cuts now.

Unfortunately, politicians have lost whatever credibility they once had on the budget to the point where action now, not a promise about the future, is the only way to convince the public that they are making progress. Thus, policymakers may have no choice but to impose the large cuts they have convinced the public are necessary despite the potential that those cuts will slow the recovery and extend the unemployment crisis.

There will be political theater along the way, particularly since, as noted above, the Treasury may be able to use accounting tricks to delay any disruption in payments. But I believe that sooner or later an agreement will be reached, and it's the details of the agreement that are of concern. I'm somewhat reassured by the fact that financial markets do not seem at all worried, and politicians must understand that if the economy tanks as a result of their actions, they'll be held accountable at the ballot box. Nevertheless, I think we are headed for budget cuts that are larger than the economy can handle as it struggles to climb back to full employment. The short-run deficit fears are overblown, and the consequences of cutting too much, too fast are not being taken seriously enough, but it's hard to see another outcome.