When will US debt be downgraded? By how much?

by John Quiggin on June 11, 2011

The once unthinkable prospect that US government debt might lose its AAA rating has suddenly become a real possibility. In fact, it now seems about as likely as not. The problem is not so much “can’t pay” but “won’t pay”. The US, like quite a few other countries, has some fairly serious fiscal imbalances, but they aren’t pressing in the short run, and there is plenty of capacity to raise additional revenue or cut spending so as to stabilise the ratio of debt to GDP at a sustainable level.

The problem is that the total value of outstanding debt keeps growing (this would happen even with a stable debt/GDP ratio) and the US Congress requires periodic votes to approve this. They are usually the occasion for some grandstanding, but this time the Republican majority of the House of Representatives is seriously threatening a refusal, unless the Democrats agree to massive (and still unspecified) spending cuts. The due date for raising the debt ceiling passed a while ago, but an actual default is being staved off by some sharp accounting tricks, which will apparently work until 2 August. The other day, to prove they are serious, the Repubs introduced a motion for an unconditional increase in the debt ceiling, with the express purpose of voting unanimously against it, which they did.

At this point, loud alarm bells have started ringing for the big ratings agencies, Standard&Poors and Moodys. They will have to decide, well before August, whether to downgrade US government debt and if so by how much.

The agencies’ problem is essentially political. For anyone who is following the news, the possibility that the US might default is obvious, and there is no reason (especially in view of their appalling performance leading up to the GFC) to think that the ratings agencies have any insights unavailable to the rest of us. But they have to make a choice and that choice will have significant financial, economic and political implications.

If the standard treatment applied to other governments were followed in this case, the downgrade would already have taken place. While it’s still more likely than not that some way of avoiding default will be found, the stated positions of the two sides are so far apart that there must be a significant probability, say 10 per cent, that they will fail to agree. A security with a 10 per cent chance of defaulting in the next few months would normally be rated among the worst of junk bonds.

That’s not the whole story of course. Most of the time, when bond issuers default, part or all of the bondholders’ money is lost for good. It seems nearly certain that even if default took place, the period in default would be short, and the US would pay interest and principal in full. Nevertheless, nearly certain isn’t certain, and once something as unprecedented as a default took place, the consequences are impossible to predict.

More importantly, the US government isn’t “other governments”. The ratings agencies are US firms operating in a US political context, and their actions will be governed by a mixture of concerns, starting with self-preservation, but also including a desire to influence US policy in a way favorable to bondholders as a group. In the medium term, that means support for a rapid return to budget balance or surplus, ideally through cuts in spending on the poor and middle class, but including tax increases if necessary.

The short run picture is more complicated. Avoiding default is presumably the main concern, but if that could be achieved by a Dem capitulation to demands for large spending cuts, so much the better. On the other hand, maintaining any kind of credibility requires a downgrade well before default actually takes place, and probably a series of downgrades as the deadline approaches. Even a single downgrade would throw financial markets into disarray (among other things, investors who are required to hold AAA assets would have to dump Treasuries and, presumably, buy the bonds of other governments). That in turn would place huge pressure on the Republicans. While the idea of “not raising the debt ceiling” polls pretty well, the reality of “destroying the US credit rating” probably won’t.

The most likely response seems to be an increasingly loud set of alarms about the need for a short-term agreement on the debt ceiling, combined (both becuase the agencies want it and because they need to placate the Repubs) with warnings about the need for a rapid return to fiscal rectitude. That’s not in fact what is needed (rather the US needs more stimulus now combined with a substantial increase in tax revenue in the long term), but it’s a message that will play well among the Serious People in Washington.

We’re already seeing this, with mid-July mentioned as crunch time. The problem is that the warnings may well not be enough. There’s no sign that the Repubs are willing to give an inch on tax increases. Agreeing to the cuts they want, with no tax increases would be politically suicidal for the Dems, which is not to say they won’t do it, but must raise the possibility of a breakdown.

{ 116 comments }

1

The Raven 06.11.11 at 6:40 am

The problem is complicated by there being two factions within the Republicans: the Wall Street faction (Pete Peterson, et al) and the nationalism-values-and-racism aka Tea Party faction (DeVos, Prince, Koch brothers, et al.) The Wall Streeters don’t want a default; the Tea Partiers don’t care.

As to the likely outcome, my guess is a compromise between Wall Street Republicans and conservative Democrats.

2

john c. halasz 06.11.11 at 6:56 am

This whole notion of a legislated debt ceiling- (unique to the U.S.)- was originally instituted with the U.S. entry into WW1, as a means of maintaining Congressional control over Executive war-making proclivities. A small historical irony.

3

Lemuel Pitkin 06.11.11 at 8:22 am

the US needs more stimulus now combined with a substantial increase in tax revenue in the long term

What’s your evidence that the second part of this is true? What’s the optimal debt-GDP ratio for the US? How do you know?

4

Tim Worstall 06.11.11 at 8:42 am

“What’s your evidence that the second part of this is true?”

The best evidence is that without a tax increase the US Govt will not be able to pay all the things it has already promised to pay. Social Security is a small part of it, Medicare a much larger part of it.

They can of course change the amounts they’ve promised to pay: but these are “cuts”.

It’s not “the govt should be larger” or even “smaller”. It’s that spending committments made years ago cannot be funded by the current tax regime. Accounting really, rather than politics or economics. Either taxes rise or future spending is cut.

5

John Quiggin 06.11.11 at 8:47 am

“What’s the optimal debt-GDP ratio for the US?”

I assume it’s finite, which would not be the case under plausible scenarios with no new revenue and maintenance of current discretionary expenditure relative to national income.

6

Myles 06.11.11 at 8:49 am

At this point, loud alarm bells have started ringing for the big ratings agencies, Standard&Poors and Moodys. They will have to decide, well before August, whether to downgrade US government debt and if so by how much.

I can’t imagine how the ratings agencies could expect to retain credibility if they do not downgrade U.S. debt. The relevant question is whether they are independent organs at all, rather than about the intrinsic credit-worthiness of U.S. debt: the question of downgrade is about the ratings agencies themselves. Being willing to open the political can of worms and downgrade American debt is the ultimate test of credibility and independence there is, and the one who does it first will lead the pack. The way to pose the question isn’t “how should Treasuries be rated given their unique nature,” but rather “if the ratings agencies are sticking their fingers in their ears and going lalalala about Treasuries, of all things, what on earth on they good for?”

The ratings agencies are US firms operating in a US political context, and their actions will be governed by a mixture of concerns, starting with self-preservation, but also including a desire to influence US policy in a way favorable to bondholders as a group.

I don’t see how “US firms operating in a US political context” is necessarily intrinsic to globally operative ratings firms.

7

Henri Vieuxtemps 06.11.11 at 8:59 am

Didn’t you all say a few weeks ago that downgrading the US debt is a ridiculous idea, and there can be no default under any circumstances?

8

Deliasmith 06.11.11 at 9:09 am

I can’t imagine how the ratings agencies could expect to retain credibility if they do not downgrade U.S. debt.

Two questions:
Do they have credibility?
And,
Is there a more secure asset than US government debt? – I mean an asset or a collection of assets comparable in size / capacity.
And if the answer is “No” a third question:
Where and when will the liquidation / closing-down sale start, and what will the sellers be looking for in return for their assets? Not dollars presumably.

9

foosion 06.11.11 at 10:18 am

Where will those looking for secure assets invest?

Consider the market chaos of late September 2008, after Lehman fell and congress voted against the bailout program. There was a severe drop in just about every financial asset other than very short-term US treasury debt.

The 14th Amendment to the Constitution provides that the public debt shall not be questioned. Many interpret this to mean paying the debt must be the highest govt priority. In other words, don’t pay any bills other than debt service.

How would that play?

10

John Quiggin 06.11.11 at 10:27 am

HV @7 No. This has has been another edition …

11

Andrew F. 06.11.11 at 11:16 am

Strongly disagree with you on this one JQ.

Here are the daily US Treasury yields for 2011.

As you can see, the markets certainly don’t seem to think there’s any significant risk of default.

Last week, Moody’s issued a press release which stated that “if there is no progress on increasing the statutory debt limit in coming weeks, it expects to place the US government’s rating under review for possible downgrade, due to the very small but rising risk of a short-lived default.” Moody’s notes that it fully expected protracted political negotiations prior to the lift of the debt ceiling. Its press release is based on some qualitative sense that the Republicans and Democrats are more entrenched this time.

But similar events have preceded the raising of the US debt limit in 2002, 2003, and 2004. See CRS Report on The Debt Limit.

What we’re currently witnessing is normal posturing. Republicans like this because it forces the Democrats to claim that they are in favor of loosening our limits on debt, and because it gives the Republicans a chance to show that they are “tough” on debt. Frankly, I think it makes the Republicans look quite stupid – which they might not understand from inside their echo chamber – but no one really takes this very seriously.

In the end, a statement by the Congressional Republicans will be issued to the effect that for the good of the country, as a temporary measure, etc., the debt ceiling has been raised, but we remain committed to blah blah blah stupid tax policy etc etc etc.

12

bert 06.11.11 at 11:28 am

Barry Eichengreen has had smart and relevant things to say about the dollar.
http://www.project-syndicate.org/commentary/eichengreen31/
This follows him saying smart and relevant things about the euro. Nobel-level smart, I’d say.

13

Brett Bellmore 06.11.11 at 11:29 am

The problem here would seem to be the deliberate conflation of default with a refusal to incur MORE debt. Failure to raise the debt ceiling doesn’t equal default, unless you presume an executive intending to violate his oath of office. It equals a balanced budget. Normally, of course, a decision not to incur more debt would improve, rather than hurt, your credit rating, as it would considerably improve your capacity to pay your existing debts going forward. Except that it’s taken as an absolute given that, regardless of debt limits, we WILL continue to spend above revenues, and that the only question is whether we’ll borrow the excess, or stiff our creditors.

That flat rejection of spending within our means, is what’s got our creditors concerned. Not the prospect that we might stop going deeper into debt. They see a currency already weakening, and from their perspective, what’s the difference between our repudiating our debt, and inflating our way out of it?

They’re waiting for signs of fiscal discipline, and seeing an administration which openly repudiates it.

14

bert 06.11.11 at 11:33 am

Of course Krugman got it for his work on trade, not on the NYT opinion page. But the Nobel committees seem to be considering topical relevance as a criterion these days.

15

Anderson 06.11.11 at 12:48 pm

Here’s my prediction if the agencies downgrade the U.S. debt: the GOP will spin that as the agencies’ concern about the amount of the debt (not the fear of default), hence as evidence that debt reduction —> spending cuts (not taxes oh gosh no) should be our top priority. And the media will go along with that spin.

16

Lemuel Pitkin 06.11.11 at 12:57 pm

I assume it’s finite, which would not be the case under plausible scenarios with no new revenue and maintenance of current discretionary expenditure relative to national income.

As it happens, this statement is incorrect.

Call the primary deficit (i.e. net of interest payments) as a share of GDP d. Call the debt-GDP ratio b.g is the growth rate of GDP and i is the interest rate on government debt, net of tax. (g and i can both be nominal, or both real.) Then in the long run, b = d/(g-i). In other words, if the growth rate of GDP exceeds the after-tax interest rate on government debt, then there is no value of the primary deficit for which the debt-GDP ratio converges to a finite level.

Figuring out the relevant tax rate to subtract from the measured interest rte is a bit tricky, but in this case it doesn’t matter. Over the long run for the US, g – i averages around 0.6 Outside of recessions, it has not been negative for 20 years. So the condition that the growth rate of GDP exceeds the after-tax interest rate is clearly satisfied for the US.

So your assertion is wrong as a simple matter of math. It really surprises me how many people make this mistake.

And even if you want to claim that the historical relationship between g and i is likely to be be reversed in the future, the statement as you made it is still not true.Rather, in that case the US may need a substantial increase in any one of tax revenue, economic growth, or inflation, or a substantial decrease in interest rates. There is no a priori reason to think it must be the first of these.

17

Lemuel Pitkin 06.11.11 at 1:00 pm

Sorry, that first paragraph should read:

“Call the primary deficit (i.e. net of interest payments) as a share of GDP d. Call the debt-GDP ratio b.g is the growth rate of GDP and i is the interest rate on government debt, net of tax. (g and i can both be nominal, or both real.) Then in the long run, b = d/(g-i). In other words, if the growth rate of GDP exceeds the after-tax interest rate on government debt, then there is no value of the primary deficit for which the debt-GDP ratio does not converge to a finite level.”

The difference is important!

18

Goldcap Toofs 06.11.11 at 1:51 pm

That flat rejection of spending within our means, is what’s got our creditors concerned. Not the prospect that we might stop going deeper into debt. They see a currency already weakening, and from their perspective, what’s the difference between our repudiating our debt, and inflating our way out of it?

Well, the difference is in one case, we’re actually repudiating our debt, whereas in the second case, you’re imagining inflation that doesn’t exist. And were creditors really concerned with “spending within our means”, they’ve had ample opportunity to signal that displeasure, starting in the early 80’s. Real Default != Monetarist Paranoia

19

Barry 06.11.11 at 2:13 pm

John Quiggin:

“The once unthinkable prospect that US government debt might lose its AAA rating has suddenly become a real possibility. “

In the sense that it was always a probability strictly greater than zero, yes. In the sense of ‘real possibility’, what proof do you have? You didn’t post any, and has been noted above, (1) the rating agencies are crooks, (2) talk like this has happened before, and (3) yields on long-term US dollar-denominated debt remain very low.

“In fact, it now seems about as likely as not.”

This is an incredibly strong statement, and requires strong proof. You haven’t even provided weak proof.

Come on, John – I have respect for you. This post was Chicago-level; I expect better.

20

ScentOfViolets 06.11.11 at 2:46 pm

Here’s my prediction if the agencies downgrade the U.S. debt: the GOP will spin that as the agencies’ concern about the amount of the debt (not the fear of default), hence as evidence that debt reduction—-> spending cuts (not taxes oh gosh no) should be our top priority. And the media will go along with that spin.

Yeppers. Welcome to Campaign 2012. Same for nonsense like voting on the Warren nomination.

21

ScentOfViolets 06.11.11 at 2:59 pm

Lemuel, can you run that by again? It sounds right, but I can’t make it come out right on paper. I was up late last night with my daughter who had to go in and take the official ACT[1] today at 8:00, so I got maybe five hours of sleep. Coffee is being consumed but the bleariness refuses to dissipate :-)

[1]They allow the use of a TI-83 calculator, but not a TI-89 or TI-92. Which is odd, since the 83 can do anything the later models do with suitable programming, and which can be either handwritten or downloaded for free from various sites.

22

bert 06.11.11 at 3:06 pm

The TI-92 can be sent back in time to terminate the guy who set the exam.
It’s not considered fair.

23

ScentOfViolets 06.11.11 at 3:14 pm

Didn’t you all say a few weeks ago that downgrading the US debt is a ridiculous idea, and there can be no default under any circumstances?

Since I couldn’t follow Lemuel right off, I went back to review that thread. The consensus seemed to be that the ratings agencies are going to do what they’re going to do, and actual expertise doesn’t really come into play. Nor does there seem to be a real possibility of default; the only real consequence seems to be that such mischief on the part of S&P and their ilk increases the possibility of raising the cost of (borrowing) money.

Well, there’s also the political consequences too of course ;-) Yet another possibility is the determination to hang on just one day past August 2 so that come election time, the MSM can have a juicy soundbite about the Obama administration causing the U.S. to “default” on it’s obligations, the definition of “default” being somewhat elastic but meant to imply the traditional sense of the word. Shades of Clinton’s definition of “Is” remark for which he was 100% correct but castigated anyway by people who knew better.

24

bobbyp 06.11.11 at 4:10 pm

The US Constitution mandates that federal debt is to be honored. To default would be unconstitutional. Congress has mandated current spending. It is the law that the executive spend what has been legislatively approved.

It would be interesting to see the administration simply ignore the ‘debt ceiling’ and pay the debt and spend the money it has been told (by Congress) to spend. It has the tools to do so.

25

StephenJohnson 06.11.11 at 4:25 pm

bobbyp 06.11.11 at 4:10 pm
The US Constitution mandates that federal debt is to be honored. To default would be unconstitutional. Congress has mandated current spending. It is the law that the executive spend what has been legislatively approved.

It would be interesting to see the administration simply ignore the ‘debt ceiling’ and pay the debt and spend the money it has been told (by Congress) to spend. It has the tools to do so.

Well, that’s a relief. It’s a good thing the US government never ever acts unconstitutionally, eh?

26

dilbert dogbert 06.11.11 at 4:32 pm

@12
“seeing an administration which openly repudiates it.”
The current administration is Obama’s. Are you talking about the bush administration? Where were the rating agencies during that administration?

27

william u. 06.11.11 at 4:46 pm

‘They allow the use of a TI-83 calculator, but not a TI-89 or TI-92. Which is odd, since the 83 can do anything the later models do with suitable programming, and which can be either handwritten or downloaded for free from various sites.’

In high school, I always got around such restrictions by using an HP-48GX. Proctors generally had little idea what it was. Moreover, since it used Reverse Polish Notation, no one would ever ask to borrow my calculator.

28

Lemuel Pitkin 06.11.11 at 4:53 pm

(My reply to SoV was caught in moderation for some reason. Here it is again.)

Lemuel, can you run that by again?

There is a fuller explanation, including the derivation of the equilibrium condition, on my blog, which my name links to. You might also want to look at:

Arestis, P., and M. Sawyer. 2008. “The intertemporal budget constraint and the sustainability of budget deficits.” In J Creel and M. Sawyer (eds.) Current Thinking on Fiscal Policy.

and

Aspromourgos, T., D. Rees, and G. White. 2010. “Public debt sustainability and alternative theories of interest.” Cambridge Journal of Economics 34(3): 433.

29

Lemuel Pitkin 06.11.11 at 4:54 pm

My replies to SoV keep getting caught in moderation. So, if you want a fuller explanation, click on my name.

30

Martin Bento 06.11.11 at 5:09 pm

I too had a look at that thread, and it looks to me like Henri’s characterization is fair. This is from April 19th. Here’s the post in its entirety:

… It was pretty silly when Standard & Poor’s started wagging the finger at the UK and expecting to be taken seriously. Trying to do the same thing with respect to the USA is pretty much the definition of tugging on Superman’s cape.

At least one economist burst out laughing on hearing about the S&P announcement. “They did what?” exclaimed James Galbraith, a professor of economics at the University of Texas in Austin, who formerly served as executive director of the Congressional Joint Economic Committee. “This is remarkable! It certainly will confirm the suspicions of those who have questioned S&P’s competence after its performance on the mortgage debacle.”

I can confirm that although it was “at least one” economist that burst out laughing, it was not “at most one”.”

Galbraith is seeing this from an MMT perspective, within which the US should just print the money. Even from an orthodox Keynesian view, the US could just print the money, within reason, under current conditions. Unfortunately, this is up to the Fed. Really, though, we and the Democrats should talk up just printing the money and get the idea to respectability (not achievable by August, unfortunately).

31

Lemuel Pitkin 06.11.11 at 5:14 pm

Henri V. is right: John Q. and Daniel Davies disagree on whether a downgrade of US debt would matter. (I happen to agree with Dsquared that it would not.) Nothing wrong with that: even the best of co-bloggers have to disagree sometimes. What’s funny is that John Q. insists on denying something that’s perfectly obvious to anyone who looks at the original post.

32

Lemuel Pitkin 06.11.11 at 5:46 pm

Oh, and while we are at it, the statement that “John Maynard Keynes argued that surpluses should be accumulated during good years so that they could be spent to stimulate demand during bad ones” is completely, demonstrably false. It’s equivalent to saying, “John Quiggin argued for a strong form of the efficient market hypothesis.”

(And, does anyone else find it slightly odd that an essay called “Reading Keynes in Brussels” doesn’t manage to cite anything the guy wrote?)

33

bobbyp 06.11.11 at 5:58 pm

“Unfortunately, this is up to the Fed.”

I’m not so sure. The president could direct the Secretary of the Treasury to sell bonds. The Fed could buy all of them. The interest is credited back to the Treasury. Currently the Fed holds hundreds of billions of private sector dreck to prop up the insolvent big banks. A few trillions more of public debt doesn’t strike me as that big a deal.

For the interesting constitutional question, see Bruce Bartlett (claims he is a conservative).
For MMT see Jamie Galbraith, Billy Mitchell, etc.
For the fed buying and holding treasuries, see Dean Baker.

The real question is this: Do we wish to sacrifice the present and likely future misery of tens of millions of un- and/or under-employed and forego potential economic output in order to satisfy the demands of the rentier class or not?

It is definitely not a question of “affordability”. That is a smokescreen used to hide the political choices we face.

34

Martin Bento 06.11.11 at 6:51 pm

bobbyp, I agree with you except that I don’t see how the schema you outline does not come down to it’s up to the Fed. The Fed gets to decide whether it’s going to buy those Treasuries, and, if it does, whether it’s going to retire the debt or resell them later.

35

James Kroeger 06.11.11 at 6:51 pm

JQ:

While the idea of “not raising the debt ceiling” polls pretty well, the reality of “destroying the US credit rating” probably won’t.

I wonder how the option of “increasing the taxes of the wealthy to pay the government’s bills instead of borrowing more” would poll?

It really needs to be understood that the Republicans will be willing to press this issue only so long as progressive economists like Paul Krugman (my favorite economist) waste time on complicated explanations of why it is a good idea to raise the debt level at this time.

Republican enthusiasm for the issue would decline rapidly if left-leaning economists took advantage of the opportunity it gives them to explain why increasing the tax obligations of the wealthiest 5% would (A) reduce the government’s need to borrow, while at the same time (B) providing a direct economic stimulus to the economy.

Increasing the tax rates of the top 5% produces an economic stimulus because a sizable chunk of the money the government would collect from those taxpayers would otherwise have been SAVED (i.e., removed from the economy). Result: the increase in G would be greater than the decrease in C + I, producing a net increase in aggregate demand.

It is NOT true that all of the money that the wealthy would have saved would have ended up in investment. 85% of all business investment is financed by retained earnings or other internally generated funds (Brealey & Myers, Principles of Corporate Finance, 2000, pp. 383-384.) This means that only a fraction of corporate investment is funded by “savings.”

There is always a net leakage of money out of the economy when money is saved, more so during recessions than during booms (demand for loanable reserves drops). The reserve ratio set by the Federal Reserve guarantees this. There is only one way it is possible to reduce the government’s indebtedness while at the same time stimulating the economy and that is if it increases the income tax rates of the nation’s wealthiest citizens.

If the economy was dealing with hyperinflation, then it would make sense to reduce the government’s debt levels by simply cutting spending. When the economy is in recession, it makes sense for the government to RAISE taxes (on the nation’s biggest savers) to finance real economic investments and reduce its borrowing needs.

36

Martin Bento 06.11.11 at 6:52 pm

Come to think of it, even if the Fed monetizes, the bonds must be issued, which might technically violate the debt limit, albeit temporarily. Does anyone know if this can fly?

37

Walt 06.11.11 at 7:05 pm

SoV: I redid Lemuel’s calculation, and it works out. Assume that the primary deficit/GDP ratio is constant, as well as the interest rate. If the debt at time 0 is 0, then the debt/GDP ratio at time t is a finite geometric series with t terms. As t goes to infinity, this geometric series converges as long as the interest rate is below the GDP growth rate.

38

shah8 06.11.11 at 8:10 pm

I think this is more a test of precisely how functional the US government is, and how long people go without deciding that Congress, especially Senators, need the lash of true pain–despite the pain it would cause everyone else.

I also think that bond market personnel is much less sympathetic to Republicans than people give them credit for. At the end of the day, no matter the narrow delusions about their relationships wrt to government regulations and taxation, they are invested in having a responsive government, and are more than most, aware of what dysfunctional government really means. Those guys? They want GDP growth, and they want it more than whatever they can loot from the US populace. More specifically rentier types that are the really bad sort of parasite, of course, doesn’t really care, so long the money keeps coming and power keeps accruing.

39

Anders 06.11.11 at 8:21 pm

bobbyp: agree that technically the govt can just keep spending by crediting accounts as it always does, just without sterilising by issuing more bonds. Given the output gap I hope few would be genuinely concerned about short-term inflationary consequences. Are there any legal obstables to overcome to pursue this course?

Lemuel / SoV et al: yes the inter-temporal government budget constraint is all about (real) growth vs (real) average interest rates paid by govt. Historical data does give comfort that we are not about to spiral asymptotically as JQ suggests, but this isn’t the strongest argument, given the unusual times we find ourselves in.

The better argument for the fact that no level of govt debt/GDP should be of concern per se for a monetarily sovereign govt is that the govt can control blended rates eg by having the central bank stand behind the yield curve and undertake to maintain rates. One can argue that the increase in private sector deposits that might ensue would lead to inflation; that would be an interesting debate to have.

Sadly, we still have intelligent types like Tim Worstall saying “spending commitments made years ago cannot be funded”, as if the US govt were just another user of someone else’s currency…

40

John Quiggin 06.11.11 at 8:38 pm

1. Henri and others need to reread the opening sentence of the post. The big difference is between “Can’t pay” and “won’t pay”. And for that matter, I don’t think there’s that much difference between DD and me as regards the power relationship between the US government and the agencies.

2. The assumption that the interest rate is below the GDP growth rate isn’t true in general, and is very rarely true if the debt/GDP ratio is high. But taking LPs assumption of a 0.6 percentage point gap, and assuming a primary deficit equal to 6 per cent of GDP, the point at which the debt/GDP ratio stabilizes is 1000 per cent. I don’t think you need to be a bond market vigilante to work out that a government owing that much will be unable to borrow at low rates.

LP is more accurate when he says “substantial increase in any one of tax revenue, economic growth, or inflation, or a substantial decrease in interest rates.” though he unaccountably omits cuts in spending as an option. Actually, inflation and interest rates can be combined to make the option “a substantial decrease in real interest rates”.

Of these a substantial increase in economic growth (raising the long-run rate by several percentage points) sounds best, but LP needs to spell out the plan for achieving this.

Some more inflation is certainly desirable in the short term (since LP is bagging my piece with Henry he knows I think so). But as a way of financing public expenditure in the long term, inflation doesn’t have a great track record. And holding interest rates down is easy enough if you assume a permanent slump, but problematic in the context (implicit in my contrast between the short run and the long run) of a recovery.

Realistically, that means the only long-run options for fiscal solvency are the standard ones: tax increases or spending cuts.

41

John Quiggin 06.11.11 at 8:49 pm

@LP #32 As I’m sure you’re aware, the standard (and sadly apposite in the current context) reference on this is “How to Pay for the War” where Keynes argued for a substantial increase in taxes on the upper classes, as opposed to the historically favored methods of deficit finance and inflation. Looking over the thread above, it seems pretty clear to me which of us is taking Keynes’ side here.

In any case, I’m not that much interested in debates about “what Keynes really thought”. If you prefer to substitute “the Keynesian economists of the post-war era” at all points in my essay with Henry, that’s fine by me. The point of the essay wasn’t historical exegesis but current policy.

42

Glen Tomkins 06.11.11 at 9:55 pm

Insolvency vs default

My understanding is that failure to raise the debt ceiling could force the US into a position of insolvency, of being unable to meet all of its many obligations, but has nothing specific to do with default, the failure to meet obligations to creditors.

Unless the US has almost no freedom to defer other of its many obligations besides actual debt, I can’t imagine that the insolvency we are told will occur on or about 8/2/11 would result in default on US debt. My understanding is that debt service is only 10% of govt obligations, and therefore you would think that the choice could be made to not honor other obligations, and such choices could keep us under the debt ceiling. If nothing else, payments of principle on debt are the one sort of obligation payment that is debt-ceiling neutral, in that if the US makes such a payment, that much debt is cleared and there is that much more “room” under the debt ceiling to roll over and incur fresh debt.

And I would imagine that the reluctance to default on actual debt per se (as opposed to other obligations), is a function more of potential downstream insolvency than of fears for the national credit rating. If the US fails to pay creditors, those creditors might be pushed themselves into insolvency, and so on in a self-propagating chain reaction.

Unfortunately, stories about this debt ceiling pseudo-crisis never seem to talk about such practicalities as how much freedom the US has in deciding which obligations to meet or fail to meet, and what sort and magnitude of obligations would have to be set aside (postponed, presumably) to keep from actual default on actual debt. Other practical questions such as: the magnitude of debt owed to what sort of creditors, the likelihood that these creditors would be forced into insolvency by US default, what sort of resolution authority the US has over these entities in case we render them insolvent by choosing to default on their loans in particular, etc., go unasked and unaswered in such discussions. If anyone has any such answers, or can point me in the right direction, that would be appreciated.

43

PHB 06.11.11 at 10:14 pm

Governments who run a deficit have two choices. One is to borrow, the other is to print money. I see no reason that the administration can’t break the GOP by simply threatening to print money.

The downside of printing money is that it creates inflation. Otherwise governments would never bother to borrow at all. The reason the government has to borrow is to keep the money supply in check and stop it growing faster than the economy.

Inflation would be a disaster of course. But a disaster for the rentier class that owns the majority holding in the GOP. Inflation would not be at all bad for the people with monstrous credit card debts or mortgages that are underwater. But it would be devastating for the fortunes of the Koch brothers and the Scaifes and the other parasites that the GOP exists to serve.

When inflation is non existent and the real problem in the economy is a lack of demand, a bit of inflation is not really a problem at all. The question is whether the impas would last long enough for the inflation to grow to the point where it could not be brought back under control.

This is a real ‘go ahead make my day’ move by the Republicans. Obama knows that he needs more stimulus but the GOP is blocking him. So he has maneuvered them into a situation where they are going to force it on him. So Obama will take the credit for the positive results while the GOP will get pinned with the blame if inflation does occur.

Another tool that the administration can use is to refuse to pay bills rather than default. Since the GOP plan is to force Obama to agree to phase out Medicare for Vouchercare I am pretty sure Obama can get away with holding up the social security checks and delaying government payments to contractors.

I really don’t think that the member for Archer Daniels Midland is going to be obstructing the debt limit raise for very long when ADM calls to tell them that their corporate welfare checks are held up.

44

Anders 06.11.11 at 10:25 pm

JQ: “holding interest rates down is …problematic in the context…of a recovery” – please can you spell out in what sense problematic?

The central bank can presumably adopt a policy of targeting a given yield curve based on what near-term (actual or potential) growth is expected to be – ie with rates increasing as growth returned. Of course this might still entail a degree of monetisation going forward (although it’s not obvious a priori how much monetisation if any there would be, if the CB switched to targeting price rather than quantum) – and so broad money monetarists would obviously cry foul. But against “quantity of deposits” concerns of too much money chasing too few goods, you have (i) automatic stabilisers kicking in, and (ii) the fact that private sector deposits may well be close to endogenous anyway (ie empirically it appears that the private sector is quite able to rid itself of its excess deposits by paying down bank debt, including via bond-for-loan refinancing).

But ultimately, what’s wrong with switching the paradigm towards seeing tax (and net bond sales) as a demand management tool rather than a means of funding?

I accept that this paradigm might not necessarily lead to any different policy recommendations (a point JQ has made before). But Krugman’s argument “look, current yields prove there are no bond vigilantes lurking” is always susceptible to the riposte “but given how harmful they can be, it is rational to act as if they could return at any time – so let’s cut govt spending”. Much stronger is to argue that bond vigilantes cannot do any harm anyway, since the central bank can offset their effects without fear of inflation taking off.

45

Brett Bellmore 06.11.11 at 10:45 pm

“Governments who run a deficit have two choices. One is to borrow, the other is to print money.”

One would think they had a third choice: ceasing to run deficits.

46

PHB 06.12.11 at 12:32 am

@Brett 45

Since the militarism budget is over 50% of discretionary spending and has been declared sacrosanct despite the conspicuous lack of any real threat, cutting spending is not very likely.

Since the GOP has decided to engage in tooth fairy economics and believe that cutting taxes raises revenue, there is no prospect of improvement there until the GOP have lost all ability to set policy.

47

Martin Bento 06.12.11 at 12:47 am

Anders wrote:

“agree that technically the govt can just keep spending by crediting accounts as it always does, just without sterilising by issuing more bonds”

I thought it was the Fed that credited accounts. As I understand, the Treasury is required to issue bonds to cover all spending, the Fed has the option of buying those bonds, and, having bought them, can either “sterilize” by reselling them later, or permanently monetize by burning them, er, I mean retiring the debt. Without getting into the deliberately tricky semantic question of whether the Fed is part of the government: 1) It is not under the control of the executive branch, so this is not something Obama can do, 2) There is a substantial formal vote and greater informal power allotted to private banks, who, as the economy’s great creditors, have interests different from the general public on questions of inflation. This is where PHB’s point comes in.

48

Brett Bellmore 06.12.11 at 12:52 am

Yeah, what’s “sacrosanct” is exactly the problem…

49

Sev 06.12.11 at 4:37 am

Obama is at fault for a great deal of this- as he is for much of the outcome of the last election. He is ‘negotiating’ with these people instead of denouncing them. If he is running out of money to spend, how about looking for some targeted savings, for example, whatever it costs the FAA to service private jets? Inform the Repubs that he will use his discretion to conserve funds, beginning with complete grounding of the private jet fleet. I strongly suspect that most people would laugh and approve. Doubtless there are other targets which might get the Repubs attention. Granted, impoundment got Nixon into trouble, but what choice are they leaving him? Of course, this presumes an actual willingness to fight them and differences worth fighting over, so it’s all hypothetical.

50

bobbyp 06.12.11 at 4:50 am

“But ultimately, what’s wrong with switching the paradigm towards seeing tax (and net bond sales) as a demand management tool rather than a means of funding?”

Absolutely nothing. Given that we have a government monopoly fiat currency and let it float freely against other currencies, that is exactly what we do now. We just discuss it stupidly.

51

Martin Bento 06.12.11 at 5:13 am

#47, I wrote:

“the Treasury is required to issue bonds to cover all spending”

meant all deficit spending, of course.

52

Anders 06.12.11 at 7:06 am

So Brett Bellmore seems to think the govt could run a balanced budget starting tomorrow, all via spending cuts.

Is anyone else able to distinguish this from trolling?

53

Agog 06.12.11 at 10:49 am

Re the debt/growth argument, didn’t Evsey Domar win this outright many decades ago?

Re Prof. Eichengreen (linked to by bert @12), did anyone else go back and immediately read this pair of sentences…

Financial crises almost always occur around the time of elections. The US has a big one coming at the end of 2012.

… a second time, and shudder?

54

Andrew F. 06.12.11 at 11:21 am

Brett, the budget has been set. Commitments have been made. Projects have been embarked upon. For the government to stop borrowing in August would not be the beginning of fiscal responsibility. It would be the government reneging on contracts and commitments, and doing so unexpectedly. It would be a terrible case of government irresponsibility which would plunge the world into a depression.

The time for negotiating on the budget has passed us. Using the debt ceiling at this point in the fiscal year as a negotiating tool is gross incompetence, a betrayal of the public trust, and very close, ethically, to a form of treason.

I think we should start a “worst offenders” list on this subject, and pour campaign contributions to their political opponents. Grossly irresponsible rhetoric about a matter like this, while the economy wavers between a second recession and sluggish growth, should have a political cost.

55

Brett Bellmore 06.12.11 at 12:22 pm

Its trolling to suggest that we could get by on the spending level of just a few years ago? Look at any combined graph of spending and revenue, and you’ll see that the revenue generally lags behind the spending only a few years, on average.

We have not, for four going on five decades, been borrowing even the interest payments, as a matter of rational economic policy. We’ve been doing it because spending buys votes, taxes cost votes, so politicians routinely spend more than they tax. Our creditors are starting to get the idea we won’t know when to stop, and reading the comments here, I don’t blame them.

56

Goldcap Toofs 06.12.11 at 12:22 pm

Well, Brett does have a point about our inability to cut defense spending, but yes, there seems to be a good bit of wishful thinking going on.

The only possible way to see that side is if we cut spending on defense in the current budget cycle to offset the huge deficit from everything else. And while that might save some entitlements (and countless poor and needful persons, and children) it would be difficult to recoup even a fraction of what is being spent elsewhere. Not to mention extended foreign military engagements and Medicare. The numbers just won’t add up.

We could call it the austerity fairy, or something. If you leave a note under your fiscal pillow, your debt is magically wiped away and everyone still gets paid! Whee!

57

Walt 06.12.11 at 12:23 pm

This was a good thread. Let me point out that an importart part of its goodness is that everyone ignored Brett’s trolling until now.

58

Goldcap Toofs 06.12.11 at 12:36 pm

Doh! Nice catch, Walt.

Back to the main point, I just can’t see the ratings agencies doing anything that would jeopardize the Bond Markets. And I can’t see the Republican legislature “sanely” destroying short-term market gains and expecting to be funded for the 2012 election cycle, so from where I sit, default is a very low, but humbly admitting not zero, probability.

59

Tim Worstall 06.12.11 at 5:13 pm

“Sadly, we still have intelligent types like Tim Worstall saying “spending commitments made years ago cannot be funded”, as if the US govt were just another user of someone else’s currency…”

Well, I dunno if that’s quite the put down you think it is. Paul Krugman (definitely an intelligent type) has been telling us for years that we’ve got to sort out the health care system because the current Medicare promises can’t be paid for without raising taxes…..which of course is his justification for health care reform and “bending the cost curve”.

60

Jacob 06.12.11 at 6:43 pm

This subject makes me totally bonkers. Why isn’t Obama on the TV explaining the consequences of default, or of dragging this out as long as the GOP seems intent on? Americans are poorly informed, but if he made a concerted effort, the media narrative would change to align more with reality. Instead, he is intent on using a milder version of the Republicans’ own Debtpocalypse rhetoric, and letting them run roughshod over the economy.

61

ScentOfViolets 06.12.11 at 6:44 pm

Do you realize Tim, what you just said? Do you realize that you just put yourself down rather effectively? Or do you need someone to explain why?

62

Anders 06.12.11 at 7:46 pm

Tim Worstall – I honestly meant it as a lament, not a put-down. You are certainly in otherwise enlightened company when you refer to taxes as a funding activity, but you strike me as possibly more enlightened and certainly less of an establishment lackey than Krugman, so it would seem easier for you to change your paradigm, professionally speaking, than Krugman. But you clearly just haven’t been convinced by the MMT spiel – which is ultimately the failing of Wray et al.

Walt – oops, forgot the rule DFTT.

63

ScentOfViolets 06.12.11 at 8:17 pm

Back in the day, Walt, we had another acronym, DNFTEC. Do not feed the energy creature. For some reason it looks better onscreen than DFTT. But maybe that’s just me dating myself.

64

dsquared 06.12.11 at 8:23 pm

Didn’t you all say a few weeks ago that downgrading the US debt is a ridiculous idea, and there can be no default under any circumstances?

John didn’t, I did, and I still believe it. I think we’re on common ground that any actual, money-lost default is pretty absurd. I, on the other hand, also believe that even the technical, couple-of-days-late default is also absurd – there are a lot of things that the Treasury can do to keep paying debt, and they will do them.

65

ScentOfViolets 06.12.11 at 8:49 pm

Well, that’s where the dueling definitions of “default” come in. The closer we get to that August date, the more political hay can be made with some sort of bastardization of the term.

The when you point out that the “default” really wasn’t, you’ll get jeered at by the usual suspects, and maybe get compared to ‘Clinton and his definition of “is”‘. Who, btw, was also quite correct. But try to explain that in less than ten seconds in an on-screen sound bite :-(

Hmmm . . . this reminds me of the attempted retconning of the recession “that happened on Clinton’s watch.” Point out that there is an official definition of the term, and that it’s used by the NBER, and people will try to wave it away as an irrelevant technicality. You know, like Clinton and his “That depends on what your definition of “is” is” :-)

66

Guido Nius 06.12.11 at 9:06 pm

The economy is stupid isn’t it.

67

Brett Bellmore 06.12.11 at 9:16 pm

Hm, all along I’ve been arguing that there isn’t any real prospect of a default, any time soon, unless the President decides he wants to deliberately arrange for one. And been attacked by people who claim it’s a ‘default’ if the government doesn’t go on spending money as though there were no debt ceiling.

How strange to find myself in agreement with SofV for once…

68

Henri Vieuxtemps 06.12.11 at 9:21 pm

“spending commitments made years ago cannot be funded”, as if the US govt were just another user of someone else’s currency…”

But Anders, ‘spending commitments’ are not about producing currency, these are commitments to provide things that can be just as hard to get as someone else’s currency.

69

Anders 06.12.11 at 9:37 pm

Henri V – I agree that real resources (unlike money) provide a binding constraint on govt spending. But what are the real resources of which the US is going to run short, constraining its spending? A lot of these commitments are for sheer manpower; unemployment sadly looks likely to stay over 7% for some time.

70

Bruce Wilder 06.13.11 at 12:51 am

As other commenters have noted, failing to raise the debt ceiling threatens to put the U.S. into a position of insolvency, not default.

An insolvency is, implicitly, a threat to the stability of the economy and/or the stability of the currency. In that sense, it would make more sense, for S&P, Moody’s, etc., to re-rate all dollar debt. U.S. government obligations are at no particular risk of default and a relative rating of AAA (if AAA is considered a mark on a relative scale) would remain appropriate, but the economy is threatened, so private debt and equity securities — particularly those denominated in dollars and tied to real activities in the U.S. economy — are subject to elevated risk. A deflation would threaten a vast array of private business activities. So, logically, if the ratings agencies were on the ball, they would be considering a re-valuation of all values. (Nietzschean economics, anyone?)

71

Brett Bellmore 06.13.11 at 1:54 am

In 2004, total government spending added up to about $14,100 per capita, with a deficit of about $1400. This year, total government revenue amounts to about $14,400 per capita. Easily covering the spending of 2004, except that, until recently, we were borrowing an extra $5-6000 per person. So, if the debt ceiling is not raised, and we don’t borrow that money, the government is faced with the ghastly, unprecedented prospect of only spending as much as it did in 2004.

Is it your position that S&P should have downgraded all US dollar denominated instruments back in 2004? If not then, why today?

72

John Quiggin 06.13.11 at 2:20 am

Brett, I agree with Walt. I don’t think your comments are adding anything to the thread, and I request that you don’t comment any further on this post.

73

Walt 06.13.11 at 7:18 am

I was briefly a convert to the Lemuel world-view, but there’s something that bothers me about the real-world relevance of the calculation. There’s another constraint, right? It seems to me that the amount of deficit cannot exceed the amount of GDP, and that under Lemuel’s calculation if the debt/GDP ratio is bigger than 1 then inevitably this will happen.

74

Tim Worstall 06.13.11 at 8:30 am

“Or do you need someone to explain why?”

Yes, you will need to explain why.

Just to repeat my position: Why does the US need a substantial increase in tax revenue in the future? Because a number of promises have been made about what will be government spending in the future. SS is part of this but the much larger part is Medicare.

Contributions have been collected from the citizenry in return for promises of future medical treatment. For some reason ( we can have lovely fights over what: maybe it’s the increasing lifespans, not previously accounted for, maybe it’s the medical cartels or the market based system or maybe it’s just the typical politicians promising lots but not being will to charge for lots. Good way to gain votes that.) the money that has been/is/will be collected isn’t enough to pay for those promises.

Thus the Government can do three things: it can reduce those future promises. This is known as “cuts”. It can raise taxes and pay for those promises. Or it can borrow more money.

At some point (an arguable one, what the point is) the government cannot borrow more money without it being self defeating. Changing the set up of the health care system (these insurance exchanges, a move to single payer, whatever) would be a “cut”….perhaps not a reduction in health care as it is delivered but a change from what was originally promised. Or taxes can rise.

JQ is arguing that taxes must rise. I’m agreeing, on the assumption that cuts or more borrowing aren’t possible/going to happen.

75

IM 06.13.11 at 8:41 am

14,100 $ in 2004 are 16,787 $ now. Now revenues were 16.1% and outlays 19.6% of gdp in 2004. 14,4% and 25,3% in 2011. Now if you take the level of revenues in 2011 and the level of spending in 2004 that gives you a deficit of 5.2% of gdp.

I don’t see how a deficit of 5.2% can be financed by stopping any borrowing int he middle of the year.

On topic: The US won’t default on any of its obligations. The crisis will be resolved by the White House giving in. As usual.

76

IM 06.13.11 at 8:50 am

But of course Medicare is not a promise of a sum of money. it is a promise of medical treatment. If medical treatment can be delivered with a slower rise of medical costs, that is not a cut. Nobody promised medical inflation 0f 6% or 8% per year.

77

Barry 06.13.11 at 12:10 pm

Walt 06.13.11 at 7:18 am

” I was briefly a convert to the Lemuel world-view, but there’s something that bothers me about the real-world relevance of the calculation. There’s another constraint, right? It seems to me that the amount of deficit cannot exceed the amount of GDP, and that under Lemuel’s calculation if the debt/GDP ratio is bigger than 1 then inevitably this will happen.”

It depends on the interest rate paid, the growth rate of the GDP, the willingness to run sane fiscal policies, and the availability of alternate investments. Please note that the US Federal debt/GDP ratio has indeed been above 1 for a bit, and this was no problem.

78

Henri Vieuxtemps 06.13.11 at 1:20 pm

Anders, suppose your monetary magic brings the unemployment rate to 0%. Unfortunately, it’s still a distinct possibility that, say, the two top quintiles get to consume pretty much everything produced in the economy, and therefore government’s commitments (assuming they are of an egalitarian nature) are still not fulfilled. 0% unemployment doesn’t sound too realistic, but apart from that this seems like a likely scenario, doesn’t it. Under these circumstances, do you agree that the government will have to tax in order to spend?

79

bobbyp 06.13.11 at 1:52 pm

Henri,

I have difficulty envisioning an economy running at full capacity where the top 40% consume “pretty much everything”. Further, tax revenues, under such conditions, would presumably be robust. See Clinton years.

The government can outbid anybody for real resources. They issue the currency.

80

Henri Vieuxtemps 06.13.11 at 2:25 pm

Well, I don’t find it too difficult to imagine. I don’t think ‘full capacity’ necessarily implies any particular pattern of income distribution.

Further, tax revenues, under such conditions, would presumably be robust.

So, then we do agree that spending needs to be, generally, financed by taxes, whether you use your own currency or not?

81

Tim Worstall 06.13.11 at 3:03 pm

“If medical treatment can be delivered with a slower rise of medical costs, that is not a cut. Nobody promised medical inflation 0f 6% or 8% per year.”

Quite true. Although it does seem that everyone, whatever their organisational structure, has a higher than the general inflation rate inflation rate for medical care.

82

Walt 06.13.11 at 3:07 pm

Barry, I’m only addressing the plausibility of Lemuel’s specific calculation, which assumes that the government runs a primary deficit as a fixed percentage of GDP every year, etc., not any other budget scenario.

83

PHB 06.13.11 at 3:57 pm

Another option would be that the US government start dumping gold from the Fort knox reserve.

This would have two beneficial effects. First it makes it clear that there is a cost for the GOP obstructionism, but the least damaging one for taxpayers.

Second it would kick the crap out of the gold market and cripple the coin scam artistes who are the principke advertisers on hate radio.

Yet another is to do what the Bush administration did in this type of situation. Ignore the legal and constitutional constraints completely. There is a precedent for this from the Republican’s own party. Lincoln did the same thing.

84

ScentOfViolets 06.13.11 at 5:38 pm

“Or do you need someone to explain why?”

Yes, you will need to explain why.

Just to repeat my position: Why does the US need a substantial increase in tax revenue in the future? Because a number of promises have been made about what will be government spending in the future. SS is part of this but the much larger part is Medicare.

Shrug. Let the record show that I did not coerce, trap, or trick Tim in any way. To proceed, the original post was:

“Sadly, we still have intelligent types like Tim Worstall saying “spending commitments made years ago cannot be funded”, as if the US govt were just another user of someone else’s currency…”

To which Tim replied:

Well, I dunno if that’s quite the put down you think it is. Paul Krugman (definitely an intelligent type) has been telling us for years that we’ve got to sort out the health care system because the current Medicare promises can’t be paid for without raising taxes…..which of course is his justification for health care reform and “bending the cost curve”.

‘Scuze me? Anders points out that people like you say that previous spending commitments cannot be funded, despite the U.S. being just a little different from your regular lender, and you say that’s not true; taxes can be raised?

Hello in there. In what universe can someone like me raise taxes to cover my previous spending commitments? For that matter, in what universe can someone like me simply print more money, etc. to cover my previous spending commitments?

Did you even think in either case before you posted?

85

John Quiggin 06.13.11 at 8:04 pm

Walt, I don’t think Lemuel’s position is quite as bad as you suggest. It’s only when debt exceeds y/r (where y in national income or r is the interest rate) that interest consumes all of national income. That won’t happen in the case of convergence to a stable debt/income ratio, such as Lemuel’s 1000 per cent (y/r=10), where interest at 5 per cent ‘only’ consumes around 50 per cent of national income.

But,t, if the primary deficit is large enough, and it is clear that governments aren’t planning to do anything about it, the interest rate will sooner or later exceed the growth rate of national income, and the debt will follow an explosive trend. Since such a trend is unsustainable, it won’t be sustained.

86

roger 06.13.11 at 8:18 pm

Who really cares what Moody’s or S&P says? Their treatment in the press like autonomous, looming powers is just a tactic in conservative image management. They work for the rich, they press policies that will be good for the rich (like, oh, keeping tax rates low for the rich), and you can make your logical deductions from that. They exist by sufferance of the U.S. government, actually. The government could, in 2009, have investigated their enterprises and utterly reformed them – and they need massive reform – but they are too valuable as supposedly objective sources, little calculating machines from outer space, instead of subordinates of the various giants of the financial industries sector.
However, they have another function, too, which we shouldn’t forget. Every con game needs a validator, who, in old fashioned parlance, is used to route the grift. How are you going to fleece people if you don’t have ‘grades’ for your bets – here’s the A tranche, and here’s the C. It looks so scientific! Surely these people know what they are doing. Routing the grift is one of the booming industries in America. That’s a problem. U.S. issued debt, not so much.

87

MyName 06.13.11 at 8:37 pm

@roger:

Maybe I’m FTT, but it’s really simple: certain types of banks are required by law to hold a certain percentage of AAA assets in reserve. If Moody et al. decides that U.S. debt is no longer AAA, the banks will be forced to switch to something that is, causing a market disruption.

More than that, if the interest rate that the U.S. can borrow at goes up because of even a temporary disruption, that can me hundreds of billions of extra money spent servicing the debt.

This is such a basic government issue that if we were a parliamentary democracy, they’d probably be forced to hold elections as the people running the government clearly aren’t able to do so.

88

John Quiggin 06.13.11 at 8:55 pm

To put the point a bit more strongly, the US ratings agencies are effectively part of the government (in the US and elsewhere), since requirements to hold AAA assets effectively outsource prudential regulation to them. So, while no sensible person would believe them, also no sensible person would ignore them.

89

roger 06.13.11 at 9:19 pm

Hmm, where have I heard the siren song that ironclad federal regulation requires that the banks hold this or that? Gulliver, here, is covered in liliputian threads he weaves himself. Here, for instance, is what happens when the rules are just a tiny bit rough on what the banks think is a nice ah, I think the last time was when the Treasury department decided, last week, that no, the banks

90

roger 06.13.11 at 9:26 pm

oops, I don’t know why that suddenly submitted. Anyway, I remember in the old days – way back in 2009 – when the rules were suddenly changed as to how banks judged their assets. Hell, I’m old enough to remember all the rule fudgery of the 2008-2010 period. A rule is only as stringent as its political usefulness, and it would be, as we all know, a one day wonder if the rules on AAA assets changed, followed by … nothing.

Here’s how hard and fast rules evaporate, from the Washington Post,
April 9, 2009 – In this blogpost http://www.bankreorealestate.com/legal-news/under-new-fasb-accounting-rule-toxic-assets-may-be-revalued-by-banks.html

“The board that sets U.S. accounting rules voted yesterday to let financial firms report higher values for some troubled assets, a controversial step likely to increase some banks’ reported earnings but also heighten suspicions that the companies are concealing problems.

The move by the Financial Accounting Standards Board was made with unusual speed under intense pressure from Congress and the financial industry, which have argued that the old rules exacerbated the financial crisis by forcing banks to overstate expected losses.”

As I say, the rules create an ‘objective’ crisis, when the crisis is useful politically, and create a problem which is solved, when the rules are politically inconvenient.

91

John Quiggin 06.13.11 at 10:25 pm

All true, but similar rules apply in lots of countries, and changing them all on a timetable set by the (in)actions of the US Congress might prove problematic. Some might judge it simpler to switch to (core) Eurobonds.

92

Anders 06.13.11 at 11:04 pm

Henri V: if we want to boost the income of the poorest 60% with various monetary benefits, we need to be careful not to unduly boost overall purchasing power relative to the level of goods and services offered by the economy, by taxing away some purchasing power from the richest 40%. Even redistributive taxation isn’t a funding activity!

93

Anders 06.13.11 at 11:09 pm

JQ: “But if [ ], the interest rate will sooner or later exceed the growth rate of national income”

I’m still hoping for someone in this forum to counter-argue why it is that a central bank isn’t able to hold down interest rates, even outside a slump. Anyone know if I have missed this?

94

Andrew F. 06.13.11 at 11:42 pm

Roger, not all rules are equally easy to change. Even the rule change you note was instituted many months after the worst of the financial crisis hit – after enormous damage had been done.

Whatever your opinion of ratings agencies, their judgments are built into an enormous number of private agreements, regulations and laws. Should US debt lose its triple A, the damage will occur too fast for any rule changes or even simply institutional coordination to be implemented. Everything will happen very quickly and will – imho – accrete exponentially.

I believe that it is the predictably catastrophic consequences of a default that cause many to discount heavily the possibility of a default. And it’s certainly true that the President has certain options should Congress refuse to lift the ceiling by a certain date. But the use of those options would be problematic in itself, as it would change the riskiness of US debt.

I only hope that those politically responsible for pushing things this far end up paying a steep political price in lost fundraising, lost institutional support, and ultimately lost votes.

95

ScentOfViolets 06.14.11 at 12:08 am

One of the nice things about this thread is that predictions are being made; moreover, there doesn’t seem to be much of a middle ground on what’s being predicted. So a month from now or by the end of August surely, we’ll get to see who was right and who was wrong.

I like it!

96

Martin Bento 06.14.11 at 1:04 am

#94. The main Presidential options I see is stop paying creditors and/or ax spending suddenly, both drastic, highly destructive, and hard to implement. The Fed has the option of monetizing, but is deliberately protected from political pressure to do so. Ben can tell Barack to stuff it. Since it is a matter of interest to the financial sector, not just the public, Helicopter Ben might fly to the rescue once again. But if there is another way to protect Wall Street, there will be no help from that quarter.

97

ScentOfViolets 06.14.11 at 1:11 am

Looks like a comment of mine didn’t go through. Anyway, what’s nice about this thread is that people are actually making predictions. Moreover, the predictions being made are pretty far apart. So in a month or two, say by the end of August at the latest, we can see who was right and who was wrong.

I like it!

98

bobbyp 06.14.11 at 1:28 am

“So, then we do agree that spending needs to be, generally, financed by taxes, whether you use your own currency or not?”

No. The reverse. Government has to spend first to collect taxes. As the issuer of its own currency, the government can purchase anything the real economy is capable of producing. Unlike any actor in the private sector, it is financially unconstrained. Taxation serves a different purpose altogether.

“I’m still hoping for someone in this forum to counter-argue…”

Not sure…but the central bank could always hold down short term rates even with the economy running at full steam. Depending on what else is happening (tax and fiscal policy, etc.) this could have negative economic consequences……so it depends on the assumptions you start out with.

“One of the nice things about this thread is that predictions are being made…”

I’d like to see the Administration ignore the debt ceiling altogether and have the issue go to the Supreme Court and/or the impeachment route. Alas, that won’t happen. There will be a messy compromise…possibly involving a lot of not quite firm commitments to ‘doing something’ about those terrible ‘future commitments’….kabuki dance…then back to normal.

99

bobbyp 06.14.11 at 1:38 am

Eurobonds? Despite all the speculation about the PIIGS departing the currency and the whole system crashing? As for the requirement of some entities to hold only AAA ratings….I’m not so sure that is germane. That universe strikes me as small. Most pension and insurance funds hold a wide array of diversified investments, not all of them rated “AAA”. Further, it is simply ludicrous for somebody to seriously consider that bonds issued by Exxon or GE are safer that US debt denominated in its own currency which can be produced in infinite amounts at the click of a computer mouse. Unlike those big corporations, the only way the US government can “go bankrupt” is to politically decide to do so. Despite all the talk, I judge this outcome to be highly unlikely.

100

roger 06.14.11 at 1:51 am

Andrew and John Q. – your scenarios would be believable if rule resets were about the U.S.’s chronic inability to pay. However, they aren’t – this is more like a Y2K problem than the Greek problem. The latter is chronic, the U.S. problem will just be using the debt limit as a political football. Perhaps traders are autistic types with short term memories and no sense of the future, but I doubt it. Rule reset would be seen for what it is – a back way through a temporary political problem that, granted, would cause a lot of rentseeking short term activity on the markets – why not make some easy money – but that will simply have no long term effect.

So, you would have a flash crash at most. This is a nothing problem. As for the suddenness of it – I don’t know, I’d be surprised if there isn’t some team at Treasury working out the terms of a rule reset right now.

101

Andrew F. 06.14.11 at 2:42 am

bobbyp, well, you can see the estimated holdings of US Treasury securities by owner-type in the latest Treasury Bulletin. Just click on Ownership of Federal Securities, and scroll to Table 2.

When you add pension, insurance, and mutual fund holdings, you end with a number somewhere north of 1.2 trillion. A forced sell-off would not be pretty. The forced sell-offs of various structured debt during the crisis provides an imperfectly analogous case.

roger @100, there are three things going here though that make me leery of resting on the fundamental value of treasuries.

First, if there is a downgrade and a forced sell-off, then the market will be flooded with forced sales, and the price will plummet. This type of event cannot be fixed in a day, and in any case the selling will flood the market for many days. And with the flood of sales you’re now in a position where the safe bet becomes the sale, regardless of what you personally think of the security. If you’re still around later, you can always repurchase it on the cheap. In the meantime, though, better protect that PnL. This is less flash crash and more “GFC II: Chapter 1.”

Second, there could be some dramatic effects on the repo business, and therefore dramatic effects on the availability of credit generally. With the economy weak already, this would be quite problematic for the economy generally, leaving aside more focused ramifications for different sectors.

The incentives for avoiding a mess like this are, clearly, enormous. And so we should avoid it. But, imho, we should stop pretending that (1) a default really wouldn’t be much of a problem, and (2) that thus far minor crises like this do not matter.

102

bobbyp 06.14.11 at 4:06 am

Andrew,

Why would there be a sell off? There is no question that principle and interest shall be remitted in full. A fund manager would be in deep trouble selling fund assets of such undoubted quality into a panicked (or so you assume) market. It would be an act of fiduciary folly bordering on criminal negligence.

It bears reminding, but you know the Fed actually control interest rates, and it could offer to buy the bonds at high prices and those who simply “must” have AAA rated securities could console themselves with cash (a financial instrument quite safe from the depredations of the ratings agencies I hear) or rush to bid up the price of Exxon first debenture bonds. So tell me…in such circumstances, would the price of those bonds go up or down?

Thanks.

Why, given your scenario, I bet Goldman Sachs is assembling a gigantic leveraged long position in AAA corporates right now!

103

bobbyp 06.14.11 at 4:16 am

dang…no edit function. The question should have been, “would the interest rate of those bonds (Exxon’s) go up or down?”

I would agree there is no denying the need to “avoid” this mess, but it is a political question, not a financial or economic one. It is in those terms that it should be analyzed.

104

Henri Vieuxtemps 06.14.11 at 8:33 am

Anders: Even redistributive taxation isn’t a funding activity!

I thought you’d say this, but isn’t it just a matter of framing, and, in the end, amounts to the same thing?

If you want to change the pattern of consumption, (for a given level of economic activity), you need to take money from one group and give it to another group. Take out of circulation and return to circulation. Tax and spend. Does it make sense to argue about terminology.

105

Tim Worstall 06.14.11 at 9:12 am

“‘Scuze me? Anders points out that people like you say that previous spending commitments cannot be funded, despite the U.S. being just a little different from your regular lender, and you say that’s not true; taxes can be raised?

Hello in there. In what universe can someone like me raise taxes to cover my previous spending commitments? For that matter, in what universe can someone like me simply print more money, etc. to cover my previous spending commitments?”

Who was talking about you? We’re talking about the US Govt.

Recall the original point. JQ says that the US needs a rise in tax revenues. He is asked “why?”. I say that it’s because promises have been made about future spending, and taxes are going to have to rise to meet that future spending already promised.

I’m really not getting why this is in any form controversial.

106

Andrew F. 06.14.11 at 12:31 pm

bobbyp @102, as I said, imho there is a very small probability of a US default. As to what investors and traders are doing with respect to that probability, I don’t know. I do know that Pimco exited US bonds in the near past.

I’m less sanguine than you are for two reasons. First, you’re assuming that there is sufficient managerial discretion at all of these entities to enable them to continue to hold US debt even in the event of a downgrade. Depending on the relevant agreements, that may or may not be the case. Second, you’re assuming that the correct act of discretion would be to continue to hold US debt in such an event. On this second point, though, the conservative move would be to sell immediately and buy other securities (unless the probability of a sell-off is so low that the absolute value of the expected value of the loss to a position from a sell-off is less than etc.) . If there is a sell-off, then you got out early; if there isn’t a sell-off, then you didn’t lose much when you sold. Finally, third, even if there isn’t an immediate sell-off, many entities would likely reduce allocations for US debt.

As to the Fed stepping in to buy… I find myself in favor of additional quantitative easing these days, but without having seen the results of someone more knowledgeable than me crunching the numbers, I’m dubious that the Fed could really do this quickly enough and at scale enough to support the price. It would be a very short-term support, regardless, and once sufficient inflationary expectations are attached to the purchases, it all becomes self-defeating.

107

bobbyp 06.14.11 at 1:51 pm

Andrew,

1.) They can’t all hit the exit at once, and it would be a foolish person who would join them. If your fears were in any way justified by evidence, you would already have seen major selling as participants try to be among the lucky “early sellers”. Please provide such evidence.
2.) The fed recently added a trillion to its balance sheet to bail out the private sector over a very short period of time….where is the inflation?
3.) Quantitative easing against the Krugman zero bound is ineffective. We need fiscal spending on a large scale to stimulate aggregate demand.

Tim W.: Taxes do not “fund” spending.

108

Anders 06.14.11 at 11:27 pm

Tim Worstall: this is controversial because you continue to put the cart before the horse. For taxes to ‘fund’ spending for a person, there needs to be a difference between the person having and not having money. This difference is coherent for you, me, General Motors or Greece, but not for a sovereign currency issuer with no foreign ccy debt.

It may well be that, if we want to honour spending promises, we will need to increase taxes in due course – but this should only be driven by inflation concerns at the time, and should be determined ex post, not a priori.

109

Salient 06.15.11 at 12:25 am

Banking loosely off Anders and earlier commenters, for fun and profit, my new let’s-be-provocative stance is to axiomatically assert that a government’s spending promises constitute an expression of intent to print the exact amount of new money necessary to meet those expenses, and the whole purpose of taxation is to insulate and protect citizens from the worst adverse consequences of the inflation that would result from fulfilling that promise-to-expand-the-money-supply literally (by partially redistributing, rather than simply expanding, the currency supply).

The question becomes, who should be expected to pay taxes, i.e. who should be expected to pay for protection from lower inflation? The obvious off-the-cuff answer is “everyone a little bit, since runaway inflation is chaotic for everyone, but mostly creditors & people in a position to be creditors, since they stand to benefit the most from low inflation.”

…I am liking this pose a lot more than I probably should.

110

bobbyp 06.15.11 at 12:39 am

Salient,

I share your guilty pleasure.

111

Glen Tomkins 06.15.11 at 2:53 am

Political Theater

This battle over raising the debt ceiling may not be exactly the particular kabuki the conventional wisdom has written it off as — just another hostage-taking like the battle over the appropriations bills, in which the Rs have no actual intention to kill the hostage — but it is nevertheless just theater that will never be pushed to the point of default on US debt.

Now, perhaps the Rs hope that the administration might be forced to deal with an insolvency created by the House’s refusal to approve a debt ceiling rise by instead failing to honor some other US obligations besides debt. Their hope would be that stiffing these other obligations will be too painful to the Ds, and they will make major concessions to make it stop.

But I doubt that we will see even that, that the administration would respond to running up to the debt limit by actually stiffing any govt obligation, by stopping payroll, or holding up SocSec checks, etc. They’ll just ignore the debt ceiling and borrow away, as much as they need to to meet all US obligations. Perhaps that would be illegal. But it would also be illegal to fail to meet all the obligations. All of the items on that list of obligations — debt payment, debt service, govt payroll, payments to contractors, retiree benefits, SocSec, Medicare, Medicaid, payments to foreign govts, etc., etc. — are obligations because Congress passed laws requiring that these funds be spent for these purposes. Faced with the choice among illegal courses of action, the administration would choose the illegal course of action that doesn’t result in disastrous collateral damage of some sort, and not the illegal course of action that does result in collateral damage.

That forced choice among illegal courses of action would be the whole point of this exercise, if the conventional wisdom is wrong and the Rs actually do mean to continue to refuse to raise the debt ceiling to the point that any course of action except ignoring it would result in national bankruptcy. Whichever illegality Obama chooses, they will finally have some actual Kenyan Usurpation to gnaw on.

The whole point would be to create a constitutional crisis. They calculate that their team, and especially their judges, will be a much more disciplined force if it comes to constitutional hardball. This would be a political battle, and one in which both sides would want to prevent any sort of collateral damage to the markets, however much violence they do to the governance of this country. That violence, especially if it becomes non-metaphorical, may have considerable downstream effects on our economy, but I don’t see much likelihood of the immediate and direct effects on markets and the economy that dominate this discussion so far.

112

Andrew F. 06.15.11 at 11:59 am

bobbyp @107: As I’ve said, the chance of a default is extremely small. This is a highly unlikely event. Nothing I’ve said would predict sellers at this point.

The question at hand was whether, should this very unlikely event occur, i.e. should the US actually default, the consequences would be grave or not.

You say that the sellers cannot all hit the exit at once. My answer is that they certainly can. Moreover, the nature of a forced sale practically requires that they do.

You say that the Fed has engaged in massive purchases already without substantial inflation. That’s very true. I don’t think we disagree on that. That doesn’t imply that the Fed can begin doubling or tripling its holding of US treasuries in August without negative consequences.

Finally, as to QE3, I’m not sure I understand your point re zero bound. Quantitative easing is used when the zero bound makes more conventional interest rate targets useless for stimulating economic activity. So yes, I agree that the zero bound lowers the probability of success of more conventional monetary policy; hence QE3.

113

bobbyp 06.15.11 at 8:26 pm

Andrew,

Ah, thank you for clarifying. So now we are discussing the consequences of a highly unlikely event? And here I thought we were discussing the implications of a rating agency downgrade of US government debt.

Sellers & exits: I disagree. When everybody tries to exit a position at once, there are generally no buyers at any price. In the case of gov. debt, the Fed can change that.

As for the fed doubling (or more) its balance sheet….show me some evidence, a theory, or even a stick drawing showing how these “negative consequences” come to be. Be specific. Please excuse me from taking your assertion at face value.

Quantitive easing is an attempt by the Fed to control the money supply. Recent observations clearly show that it does not, a fact that many macroeconomists conceded some time ago. Further, these efforts, i.e., flooding the system with reserves, have not resulted in more money in general circulation (i.e., loans). So just how long shall we beat this dead horse? The results of quantitative easing are hugely disappointing. Further, you implicitly aver that such efforts will, if taken to some as yet undefined extreme, have “negative consequences”. I guess that’s even more reason to try something else.

As to the original question posed in this post, I present the example of Japan. Standard & Poors downgraded Japanese government debt in January. Interest rates have gone down since. There has not been any panic selling of the now AA- debt by Japanese pension funds and insurance companies that I am aware of. Their debt/GNP ratio is over 100%. The world has not ended.

Thanks.

114

Andrew F. 06.16.11 at 4:37 am

Bobbyp, yes, I think the downgrade, as well as the default, are highly unlikely.

Those forced into selling would be those required to own AAA rated securities. There are plenty of market participants who will not be subject to such requirements.

As to quantitative easing generally, the type used in the US wasn’t simply focused on increasing the money supply. Instead it was focused first on increasing particular types of credit for businesses and households, and focused second on increasing the wealth of households and investors. These two efforts led to increased wealth and consumption, and lowered savings rates. As it has wound down, the effects have as well.

As to Japan, I think it’s in such a different position – I’d imagine that their bonds are held in larger percentage by domestic entities (95% or so) and that those entities are less free than those in the US might be to begin dumping them, among other things – but I haven’t spent much time on the case.

115

bobbyp 06.17.11 at 1:38 am

“I’d imagine……”

Well hey. Two can do that! I’d imagine your hypothesis about “forced sales” is all wet. There ya’ go. Absolute proof.

116

Andrew F. 06.17.11 at 4:13 am

It might be Bobbyp. It all depends on what’s in some of the various investment agreements, guidelines, and regulations regarding triple-a securities. And there’s nothing wrong with agreeing to disagree, or having less than absolute proof on a point. This is a comments section on a blog, after all, and we both have lives.

Comments on this entry are closed.