The Foolishness of Default Denialism

Against Yohoism: why breaking the ceiling would be bad.

A craze is sweeping the nation, the idea that failing to raise the debt limit would not be an abomination. The most outspoken supporter of this view in Congress is Rep. Ted Yoho (R-YOLO), who told the Washington Post on Friday that “it would bring stability to the world markets.”

A weaker version of this position is one more commonly held among conservatives: that the Treasury department can just prioritize payments to bondholders, that those bondholders will be pleased and that Treasury bills will continue to roll over smoothly. And you know, the federal government is too big anyway, so not spending any money beyond what’s coming in from taxpayers and what’s being seized from holders of preferred stock in Fannie Mae and Freddie Mac is probably a great idea.

Fortunately, cooler minds seem to be succeeding for now, and Speaker Boehner’s plan to raise the debt limit for six weeks could provide some temporary relief. But I would not be surprised if in six weeks we were right back where we are now. In that case, the view that crossing the X date is no big deal will almost certainly make a comeback.

Both the moderate and the extreme renditions of this view are dangerous. First, the idea that financial markets are pleased by the way in which the Congress and the President are setting budget policy is one that must have originated in Cloud Cuckoo Land. In the summer of 2011, Congress came dangerously close to breaching the debt limit, and a downgrade on U.S. sovereign debt quickly ensued. As Standard & Poor’s put it back then: “More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.”

Although we are at least a week away from the X date, when Treasury runs out of borrowing capacity, markets have already started to express similar discontent. The interest rate on Treasury bills that the government pays to borrow has risen to its highest level since 2008, reflecting concern that the government will fail to meet its obligations to bondholders. Under the Yoho paradigm of financial markets, these rates should, of course, have gone negative by now: we’re almost there, our spending is almost controlled, we’ve almost succeeded at keeping the debt limit in place! The cost of insurance against a U.S. default has also soared; a one-year U.S. credit default swap is now ten times as expensive as it was on Labor Day. Again, not exactly a vote of confidence for Yohoism.

Now, the second camp of people less than concerned about hitting the debt limit is certainly more reasonable. Martin Feldstein, the George F. Baker Professor of Economics at Harvard University and formerly chairman of Ronald Reagan’s Council of Economic Advisors (disclosure: my Ph.D. advisor), certainly not a Yohoista, wrote the following in a widely circulated email this week: “The government may not be able to separate all accounts into "pay" and "no pay" groups but it can certainly identify the interest payments. An inability to borrow would have serious economic consequences if it lasted for any sustained period [.]”

This may be true, but it requires tremendous faith in Treasury’s ability to adjust its IT systems to a whole new world. Especially in light of the widespread problems with the rollout of the Obamacare exchanges this past week and a half, that faith is likely to be shattered quickly, and the magic-carpet ride of payment prioritization will probably be rocky, not romantic or rosy.