Capital Ideas Blog

Economists weigh in on debt debate

By Vanessa Sumo
October 10, 2013

From: Blog


How bad would it be if Congress fails to raise the debt ceiling on October 17? It’s hard to predict the consequences of something this unprecedented, because the US has never before failed to pay its debts on time. But the outcome will probably be in the range of bad to extremely bad.
 
Most of the economists who make up the IGM’s economic experts panel seem to think so. When asked in a recent survey whether they think American families and businesses would likely suffer severe economic harm if the US fails to make scheduled interest or principal payments on government debt securities, 75 percent of the economists on the panel agreed or strongly agreed. This figure goes up to 91 percent when responses were weighed by the experts’ confidence in their answers.
 
If Congress doesn’t raise the debt ceiling and fails to pay its debts on time, investors will likely start perceiving government bonds as riskier and demand a higher risk premium. This will raise borrowing costs for the government and also for businesses and households, because rates on US Treasuries affect all other lending rates. Investors are already showing signs of anxiety as yields on some Treasury debt have started to rise. Without enough tax revenues to cover expenditures, the government will have to slash federal spending and perhaps even delay social security payments, both of which could push the economy into recession.
 
The list of bad things that could happen doesn’t end there. If the US defaults on its debts it could jeopardize the US Treasury bond’s status as the world’s safest and most liquid asset. “Giving away the status of ‘risk free’ to make a political point is the height of stupidity,” said Chicago Booth’s Richard Thaler, referring to the current political fight in Congress that forced the government to shut down last week and is now threatening a timely resolution to increase the debt ceiling. A debt default could also “put the [US dollar’s] status as reserve currency in play,” noted Chicago Booth’s Anil Kashyap. “There would probably be forced selling,” Kashyap added.
 
A debt default could have severe effects on financial markets. “The extent of financial disruptions is hard to predict,” said UC Berkeley’s Barry Eichengreen. “[The] length of default will matter.” One place a default would affect the financial markets is in the repo market, a critical source of funding for financial companies, where borrowers pledge US treasuries to investors in exchange for short-term capital. A well-functioning repo market depends on whether markets view US Treasuries as safe collateral.
 
Stanford University’s Caroline Hoxby pointed out that “the federal government could make its interest payments on current debt even if the debt ceiling were not raised.” While that’s true, market participants have said that financial markets could still react negatively if the government defaults on other commitments, such as payments to pensioners.
 
The panel was more split over whether, with or without a default, current uncertainty over the government’s future taxing and spending policies is likely to depress private investment and hiring, to such an extent as to reduce GDP growth by at least a quarter of a percentage point over the next year. About 31 percent of the experts agreed with this statement, while 39 percent were uncertain. Some of those who were on the fence remarked that GDP growth could take a hit but the magnitude of loss would be difficult to estimate.
 
Heightened uncertainty over future economic policy can be damaging to economic growth if it makes consumers defer spending and businesses cut back on capital investments and hiring. A research paper by Chicago Booth’s Steven Davis with Stanford University’s Scott Baker and Nicholas Bloom found that an increase in policy-related economic uncertainty, similar to the historically high levels it reached between 2006 to 2011, which included the Lehman Brothers bankruptcy and previous debt ceiling impasse, could reduce industrial production by 2.5 percent and employment by 2.3 million jobs.
 
Less policy uncertainty is the better policy. “A comprehensive tax and entitlement reform, one that would fix US fiscal problems for the next 40 years, would be a great ‘stimulus package’,” noted University of Chicago's Nancy Stokey. 

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