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The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

Stupid Debt Brinksmanship



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As Brian Beutler summarizes over at Talking Points Memo, a number of Republican officials (including Pat Toomey and Paul Ryan) are relying on advice that a brief default on federal bonds would not rattle the financial markets:

Ryan told [CNBC] that he talks to “lots of bond traders” and “lots of economists” and they all say that investors are willing to put up with a default of “a day or two or three or four” if it produced massive budget changes as part of a Capitol Hill debt limit deal.

This is a very dangerous thing for policymakers to think.

The problem is not that these traders are necessarily wrong. None of the previous debt limit impasses has led to a temporary bond default, and it’s possible that a brief default really would be just a minor hiccup. Unfortunately, it’s also possible (as many other voices on Wall Street are warning) that a default would permanently raise Treasury spreads, drive investors to find alternative safe havens, cause a double-dip recession, and unleash various other evils. So, if they are willing to create the possibility of a default, Republicans in Congress are willing to expose America to severe downside risk.

It’s important to step back and consider the stakes here. Republicans say it is important, above all else, to rein in federal government spending. But the risk with excessive spending is not that government will literally become unaffordable or that we will be unable to service our debts. The United States has tremendous available fiscal capacity, as demonstrated by significantly higher tax burdens in most other first-world countries. The real risk of elevated spending is that we’ll adopt a permanently higher level of taxation.

That is a risk, but not a catastrophic one. While there is a link between government spending and economic growth, it is not as strong as conservatives like to believe. For example, Mueller and Stratmann find that a one percentage point rise in government spending as a share of GDP will tend to reduce annual GDP growth by a bit under one-twentieth of a percentage point. If we take Simpson-Bowles as an example of the sort of deficit deal that might be achieved in the medium term without the need to flirt with a bond default, then we’re talking about a difference of one to two points of GDP in government spending compared to an all-Republican plan.

There is also nothing special about government spending as a share of GDP as opposed to other determinants of economic growth, such as rule of law, freedom of contract, immigration policy, free trade and the structure of the tax code—not to mention policies on infrastructure, land use and education. Basically, we could make up a sub-0.1 percentage point hit to long term GDP growth with policy improvements elsewhere.

Which is to say, it does not make sense to create a risk that U.S. Treasuries will be dislodged as the world’s safe-haven investment as a strategy to shift the size of government by a percentage point of GDP or two. Winning this fight is not so important that it makes sense to throw caution to the wind, but that is what Republicans in Congress appear willing to do. The gamble looks even worse when you consider that a debt-limit-impasse-gone-wrong would not necessarily lead to Republicans getting their way on the long-term fiscal adjustment.

Unfortunately, I think the sanguineness about a bond default reflects a feeling among some conservatives that it might not be such a bad thing if it became much more expensive for the federal government to borrow money.

Finally, I’d note that I still don’t think there will actually be a default on bond interest payments for any period of time. While some congressional Republicans may be OK with a brief default, it’s ultimately up to the Administration to decide whether to pay interest or not, and I still believe they will prioritize interest payments over other obligations. Nonetheless, it’s disconcerting that some Republicans are ready for a default, even if Tim Geithner is here to save them from themselves.



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