Debt Ceiling Dynamics

...chaos, painful chaos...

What would happen if Congress refuses to raise the debt ceiling? The answer is chaos, painful chaos that would have horrific short-term implications for not just the US but the global economy. Here's why.

Refusing to raise the debt ceiling of course could mean that the government is unable to send out social security checks in a timely manner, or otherwise pay its bills. Mind you, these are all programs duly legislated with expenditures authorized by Congress. So the proper way to do things is to change the law. If members of Congress don't think they can get re-elected if they do that, then ... but let me stick to the economics.

The real nightmare is the uncertainty this would throw into credit markets. The impact would be concentrated in short-term markets, because that's the debt that (by definition!) falls due. An awful lot of our economy is tied to those markets – money market funds, the prime rate that affects small business loans, car loans and credit card interest rates, and of course that also affects the holding cost of financial institutions with short-term funding needs. The Federal Reserve can work to keep the Federal Funds rate low, but that's an arm's length removed, and at best helps out banks. As we've seen, however, the straight banking portion of our financial system is a shadow of its former self, while the shadow banks have taken over.

Normally there's virtually no capital gains risk, upside or downside, in short-term markets – one reason that interest rates are typically much lower. But what if you have a Treaury maturing 5 days from now, and you're not sure it will be good. Now you will get your money, sooner rather than later, but the certainty is gone. Suddenly you're in a seller's market, and face a loss if you try to sell it -- but the possibility of no money on day 5 if you don't.

Now at today's interest rates – let's say 0.04% pa, the rate on a one-month bond at the end of December 2012 – well, a $1 million bond earns roughly $1 a day. But if you're a corporate treasurer that really needs the money to make payroll, you may well prefer to take a $100 loss on your $1 million – that is, get $999,900 today – than have a bunch of workers seeking to lynch you because their car payment check bounced. But that means a 4% interest rate – and if we look at what happened when Lehman failed, rates could go much higher.

That doesn't sound like much, but it would put money market mutual funds at risk, as many have committed to holding short-term Treasuries to minimize risk. Ditto foreign exchange trader from around the globe. With trillions of dollars traded every day, a jump in interest rates of that magnitude would throw a monkey wrench in the economy that would make the fiscal cliff look as flat as a bowling alley.

So I think that an administration pushed into a corner would in fact be willing to do almost anything, even delay social security payments, to avoid a bond default. But market managers won't want to place their careers at risk of politicians, most of whom are lawyers, failing to get their priorities straight. Unlike with the fiscal cliff, a last-minute compromise will thus still cause chaos.

I try to avoid hyperbole, but to me it would be treason – far more dangerous to the US than spilling top secrets – for Congress to use the debt ceiling as a political tool.

...mike smitka...

Economic Policy: Treating Symptoms, Treating Causes?

Mike Smitka

...Inaction is the Best Medicine?...

The question: can we use an analogy from medicine, that we should treat the disease rather than the symptoms?

1. Of course treating the common cold or a mild case of the flu may not be worth the effort (tamiflu?!) -- take 2 aspirin, drink lots of fluids and go to bed.
   
2. Where there is no direct treatment, or the symptoms themselves are dangerous (and the diagnosis pending) then treating symptoms may be the best policy. That's the standard plot on House, someone's dying, treat the symptoms while the detective work progresses. Of course, to fill up the hour the first choice backfires (or works but then new problems crop up).
   
3. Sometimes though the effects of the disease don't, or won't ever, reverse themselves. The stroke is over, blood is flowing but...or the rheumatic fever has subsided, but the heart valve is shot and won't heal itself. Treat the aftereffects, not the cause.
4. The patient may not cooperate. In the (really) old days of cable bindings skiers broke bones with alacrity. You could set the bone and mostly get it to heal. But keep on skiing ... well, you haven't treated the disease and next time it may be a joint that can't be fixed. I suppose a better example is obesity: few doctors will tell someone "get lost until you lose weight." Now it's good for business, and many patients may be too addicted to snacking and watching TV to shift their net caloric intake (fighting alcoholism may be easier, after all our bodies can survive without drinking, but you can't stop eating). In economic terms, political economic calculations may mean you know what you ought to do, but don't.
   

So in fact when I think more deeply about the medicine analogy, it suggests there is no quick answer for what an economist ought to propose.

I still hold that best practice remains diagnostic-based treatment. But let me return to the list above.

1. Being reticent to act is not a bad thing. There are always "shocks" to an economy, good and bad, but in developed countries our economies are both very big and resilient. The effect of most shocks is transient, even when the impact can with hindsight be discerned in the data. Policy has side effects, it can be hard to change and hard to reverse if it creates "winners" (an example is the capital gains tax exemption in the US, originally put in as a response to the distortions caused by the late 1970s inflation). In the macroeconomic context, textbook models suggest that adroit fiscal and monetary policy can eliminate the business cycle, but getting the timing right is hard because the "normal" cycle is short (reverses itself) and we tend to use the wrong policy tools (monetary policy to slow an economy, fiscal policy to boost -- the opposite is ideal). So we have both side effects (higher real interest rates coming and going) and may be giving the wrong medicine (no need to push down body temperature once the fever's gone).
   
   The losses from Japan's earthquake were horrific and even if we can rebuild, we reverse death or undo privation. But from the perspective of the economy as a whole it was still a fairly small event, and even if Toyota and Honda lost a lot of production, rivals were less affected. So the underlying competitiveness and complexity of a modern economy means there are lots of substitutes. So while there was a short-term impact there's no reason that macroeconomic policy need change. (But every reason to devote resources to recovery...at the local "microeconomic" level.)
   Back to the practical problems of real-time policymaking. This was Milton Friedman's bete noire -- after all he used the same Keynesian analytic framework, so it was not theory that drove him but pessimism about policy makers and the policymaking environment. He wanted a world of rules. Unfortunately the world proved too complex for simple rules, which he himself recognized in his latter years. As long as we permitted innovation in financial services, rules would need to evolve. Ideological correctness is insufficient: with irony, it was Greenspan the conservative/libertarian who poured fuel on the flames of a financial system fixated on short-term returns while trading long-term instruments. Financial innovation provided insurance policies, yes, but not as fast as financial innovation multiplied risk.
2. Does the economy always quickly recover? Clearly, no. We should be chary of panicking at every sign of recession or the cry of inflation that comes every commodity spike (we are wont to confuse shifts in relative prices from aggregate inflation when it comes to the prices of gasoline and veggies.) That's point #1.
   
   But neither should we bury our heads in the sand and say things will pass when all evidence speaks to the contrary, when unemployment or inflation is suddenly a multiple of desirable and presumably feasible levels.
   So when the patient may be dying, provide stimulus. If that doesn't work, provide more. It's not hard to back off of emergency measures -- the Civilian Conservation Corps was folded pretty quickly. [President Eisenhower found it harder to trim the War Department, by then artfully renamed the Department of Defense, but its growth was never premised upon macroeconomic necessity, even though commentators from at least the 19th century had pointed out that wars on other people's land weren't so bad, particularly when in the post-draft era they are from a policymaker's perspective fought by other people's children.]
   Keynes in fact was a good example. On matters economic he was a conservative, but he had warned about the large macroeconomic flows built into Treaty of Versailles reparations as something that would be beyond the bounds of normal macroeconomic adjustment. Then, in the 1930s, he found himself staring at 20% unemployment in Great Britain, well, it was clearly not a run-of-the-mill downturn. Worse, he was looking into the abyss of socialism -- in Germany, the National Socialist Party of Adolf Hitler, and there was populism and radicalism at home.  Something was sorely amiss, and sitting on his hands wasn't an option, even if as the creator of modern macroeconomics he was at times groping and unsure of his way (or more precisely, incoherent.) Keynes didn't view his task as that of a plumber fixing the odd leak along a dike; he saw a dike about to collapse with raging floodwaters set to inundate hist beloved England.
3. Macroeconomic damage is fundamentally irreversable. If you've lost your job and can't find one for 9 months, it becomes increasingly difficult in many industries to get hired back to a similar position. You can never make up for lost consumption -- the pain of telling kids "no" can't be undone. When it lasts long enough, small businesses fail and teachers get fired and roads don't get maintained and communities lose coherence. If you've lost your house, it can take a while to rebuild your credit rating, not to mention build up the downpayment on another house. And if in the interim you've been unable to afford healthcare and haven't been able to pay college tuition, there's long-term damage. These affect society as a whole, too, and not just those hit directly by economic trauma. So while we may not be sure what's causing unemployment, we certainly can engage in direct job creation or pay extended unemployment benefits and offer subsidies to state and local school systems and hospitals to mitigate the side effects of recession.
4. A financial system that collects fees up front for selling assets that are long-lived has a built-in conflict of interest. Straight bank loans to small businesses are less problematic, because they tend to have a shorter maturity (lessening the mismatch between the time horizon of a bank's assets and liabilities) and because banks can't sell such loans to others as readily and so are more careful in their decision-making. (Asides: the 90-day line-of-credit is illusory, since most businesses structure themselves as ongoing entities; maturity mismatch remains. Likewise the bankers who originally made the loans may well have moved on, and not suffer the consequences of bad decisions.)
   
   But straight banking is now a small fraction of our financial system. The securities industry, which is what banks have morphed into, is huge, and with a regulatory system that emphasizes the letter of the (common) law, we seem unable to restrain the growth of "shadow banks". When money is "tight" shadow banks and securities firms have a harder time raising funds, and the yield curve can work against them. But it's like a case of AIDS, with a combination of basic regulation and normal monetary policy we can restrain its ability to cause illness but to date we can't eliminate HIV entirely. Lapses in medication lead to bad outcomes.

So perhaps medical analogies have their use. There is however no (simple?) diagnose-and-treat lesson to be had. Rather, it is that the economy, like the human body, is very complicated, and textbooks will only get you so far. Medicine remains rooted in apprenticeship. Economics must as well

Perry and Treason

Mike Smitka

...(your) Unemployment is Good! (for me)...

Treason is a serious charge; I would hope that a presidential candidate would not bandy it about lightly.

But first, I find it unsettling that Rick Perry seems to have flunked Economics 101 in his diatribe yesterday against the Fed, that it should not "print money." He fails to understand that in our (and every other) modern economy banks create money, not the government. That was true when the US was on the Gold Standard, too. The Federal government does print paper bills – but it is Treasury that oversees the Comptroller of the Currency; the Fed has nothing to do with it. Is it too much to ask that someone wanting to be chief executive know a little bit about the tools of governance, or at least listen to people who do?

Second, Perry exhibits a lack of intellectual principles. He charges the Fed with treasonous behavior. He seems to be unaware of Milton Friedman's 1963 magnus opus with Anna Schwartz, A Monetary History of the United States, 1867-1960. Whatever flag of conservatism Perry might be claiming to wrap himself in, it's not Friedman's. Friedman and Schwartz do deride the Fed, justly, for turning the 1929 market crash into a depression – but for not printing enough money, not for printing too much!^{[Note 1]} So Perry wants not only to repeat the budgetary idiocy of Herbert Hoover, he wants to repeat the monetary idiocy of Roy Young and Eugene Meyer, the successive Chairmen of the Board of Governors of the Federal Reserve System during 1927-1933. So Perry makes it clear that he has no conservative principles, only campaign ones.^{[Note 2]}

This campaign focus extends to moral principles; Perry displays an ethic that is, well, so self-centered that I find it hard to fathom: he wants the Fed not to print money because it might create jobs and lessen his election prospects. Yes, for his own vanity he wants to keep millions of Americans unemployed.

I'm resigned to the occasional bad student; academic firepower isn't all that matters. Diligence does; even my bad students do their homework, and learn to stick to a consistent line of argumentation. But to lack principles -- well, at Washington and Lee Honor Code violations get you expelled, though guilty verdicts in practice are hard to come by.

I hope primary participants quickly expel Perry from the race. As President he would take an oath to uphold the Constitution, the opening sentence of which states that one purpose of the Federal government is "...to promote the general Welfare...." He must believe that once someone is unemployed they are no longer worthy of being considered a citizen. But that's not what the Constitution says: even slaves counted (though not for much).

Perry is apparently quite willing to destroy livelihoods for his own political benefit. But I don't bandy around the charge of treason lightly; however reprehensible I find that stance, I don't think it merits accusing him of seeking to destroy the country.

 

Note 1: Ben Bernanke lauds their work; I do as well, though I am uncomfortable with the monocausal view of the causation of A Monetary History. The link to Wikipedia provides a start for those who want to know more of the details.

Note 2: Obama is little better in practice: his stated goals are not pernicious, he on occasion talks a good talk on policy. But refuses to walk the walk, neither leading nor following through. Perhaps he too cares only about his standing in the polls.