The End is Not Nigh!

The End is Not Nigh!

Why not increasing the U.S. debt ceiling may not be the end of the world

by Joseph Cox

“The end of days is nigh,” or at least that’s what you hear from President Obama when he says, “We would risk sparking a deep economic crisis….For the first time in our history, our country’s triple-A credit rating would be downgraded. Interest rates would skyrocket on credit cards, on mortgages and on car loans, which amounts to a huge tax hike on the American people.”

In fact, nobody knows the consequences of a debt deal – or of the absence of one. But maybe not raising the debt ceiling actually would benefit the economy. There are three reasons for this:

1) Treasury rates are not necessarily the lowest rates

2) A rise in inflation may release productive money

3) A drop in government support could reintroduce healthy moral hazard into financing and investment

Let’s go through these in detail:

Treasury rates are not necessarily the lowest rates

The assumption is that a default on the part of the U.S. Government would result in high interest rates for you and me. In fact, it would raise Treasury rates. But a huge proportion of existing U.S. debts (both government and individual) is fixed. So, many old debts actually would be reduced through inflation.

But even with new debt, a rise in Treasury rates might not have the impact people are describing. Consider the following:

1) Last year a few companies’ debts (like Coca Cola) traded at a premium to U.S. debt. Their debt (denominated in dollars) was considered more valuable than the government’s. This means a business can have a credit rating superior to the credit rating of the U.S. government. More critically, a dollar can have a value superior to the faith in the government issuing it. At that point, the differences were tiny and only a few debtors were included.

2) We have long equated currency values with an economy and a government’s ability to pay. If the government can’t pay, the economy must be terrible and the currency must be bunk. But the U.S. might be in a unique situation of having an economy that can pay, but a government that cannot. The inability to raise the ceiling might just tell dollar holders that there is a cap on the dollar-denominated monetary supply (like Treasury Bonds). In other words, it might reassure investors that the currency can’t be devalued by the reckless action of the government.

3) Given the above, there might be a huge number of debtors whose debt is worth more than U.S. Treasuries. Even if the government can’t pay its bills, lenders may assess that your ability to pay isn’t a whole lot worse. You may be able to issue debt closer to (or perhaps at a better rate than) the U.S. government.

All of this isn’t to say an interest rate rise is out of the question. With many debt rates, such as those for credit cards, set (at least for now) against Treasuries, there will be a short-term rate squeeze. In fact, interest rates could well rise, but I’d posit the impact could be far from catastrophic. In fact, it might be beneficial.

A rise in inflation may release productive money

As you know, banks haven’t been lending much money. Banks are not alone in hoarding cash. Apple has $76 billion dollars. Why should they lend it out or invest it? A dollar held today is worth just about the same as a dollar held a year ago. So why risk loaning it to some fellow in a risky economy? You could lose your job doing a thing like that.

But if there is inflation, that rule no longer holds. Banks (and Apple) MUST invest to get a return. And they won’t be able to buy Treasuries, because those won’t be available (in any massive volume). So they need to invest in the real economy. This may unleash a flood of liquidity – a flood of investment, a bout of inflation with the new money in the system – and more prosperity. Those who have will need to use. They can’t just sit on their greenbacks.

Moral hazard, welcome back

Cutting may provoke a national debate about spending priorities – on the part of government. But the more important debate might be investment priorities – not by government, but by companies and private citizens.

The government offers explicit or implicit guarantees to all manner of companies and programs. People invest money in wasteful and stupid enterprises because they are promised a return. But what if Fannie Mae, Freddie Mac and countless banks can’t rely on government support? What if people don’t know that Social Security and Medicare will pay out?

Maybe investors would place higher priorities on real investments that return real money? Perhaps investments would be reprioritized around actual wealth creation.

Maybe private citizens would recognize the real risks of government-guaranteed Social Security and Healthcare – facilitating the reform of these broken or breaking systems.

If moral hazard entered government-backed markets, then market forces may reenter banking, mortgages and myriad investment opportunities – releasing a real rise in wealth as money flows to wealth creators instead of to protected friends of our nation’s political class.

Do I want a debt ceiling increase? Yes. First, chaos is scary; second, a sudden cut-off would cause significant short-term pain; third, I don’t trust the Executive Branch to distribute limited funds to grammas first and Fannie Mae last.

Nonetheless, I don’t think the possibilities of a fixed ceiling are as massively negative as many are suggesting.

Joseph Cox is a guest author for Cascade Policy Institute. He earned his undergraduate degree in Intellectual History at University of Pennsylvania and a Masters in Financial Analysis from Portland State University. He works in Finance and IT with a focus on providing productive views into complex problems. He lives in Portland.

Cascade Policy Instituteis Oregon’s free market public policy research organization.