Economix: On Debt Talks, a Lose-Lose-Lose-Lose Situation

Endemol/NBC Universal Sorry, Howie Mandel: Deal or no deal, the American economy probably still loses.

1:07 p.m. | Updated with a fifth (less likely) scenario.

Almost whatever happens this week with Washington’s debt talks, the economy will most likely be worse off.

As Dean Maki, the chief United States economist at Barclays Capital, put it: “The basic issue is that the U.S. is on an unsustainable fiscal track, which is pretty widely agreed upon. From that point, none of the choices are fun.”

CATHERINE RAMPELL

Dollars to doughnuts.

Here are the likely scenarios I see:

1) Held up by disputes over how to reduce deficits, Washington doesn’t raise the debt ceiling in time. As a result, the Treasury stops paying debts it owes.

If that happens, the rating agencies downgrade the United States’ debt. The cost of borrowing for the United States government shoots up, since lenders demand higher interest rates from borrowers that are less trustworthy. Many other interest rates are pegged to the cost for the United States to borrow, making interest rates on all sorts of other loans, like mortgages, rise too. Credit markets freeze up, crushing an already-feeble economic recovery.

Macroeconomic Advisers predicts that failing to raise the debt ceiling in time — even if the delay is only one month — will very likely result in a new recession. And because it’s more expensive for the United States to borrow, the United States debt gets even larger, the exact opposite effect from what fiscal hawks are hoping for.

2) Held up by disputes over how to reduce deficits, Washington doesn’t raise the debt ceiling in time. But rather than default on its debt, it diverts money from other spending into paying back bondholders.

That could mean that Social Security checks are not sent, soldiers in Afghanistan and Iraq are not paid, and all sorts of other consequences.

In addition, bond markets might still freak out because the threat of default remains, so interest rates could rise anyway and cause all the terrible consequences in Scenario No. 1 (potential second recession and even bigger federal debt).

3) Washington comes up with a deal to raise the debt ceiling, but it amounts to less than $4 trillion in savings.

Standard Poor’s has said that just raising the debt ceiling is not enough; without a “credible” plan for at least $4 trillion in savings, the United States might still have its credit rating downgraded. That could, again, mean higher interest rates and all the other terrible consequences of Scenario No. 1.

4) Washington comes up with a deal to raise the debt ceiling that amounts to more than $4 trillion in savings over a near-term horizon.

The credit rating agencies are appeased, but such severe austerity measures put the fragile economic recovery at risk. The states in particular are anxious about what major spending cuts mean for them and for the many social safety net services they provide with federal support.

As Bruce Bartlett and others have written, similar fiscal tightening during a fragile economy happened in 1937. Those actions resulted in a severe second recession and prolonging of the Great Depression, partly because it was coincident with monetary tightening as well. While a sharp, sudden monetary tightening seems unlikely, the Fed is at the very least pulling back on its easy monetary policy with the end of its second round of quantitative easing.

As The Wall Street Journal’s Kelly Evans observed, Japan had a similar experience in 1998, when austerity measures were followed by a recession and a widespread sell-off of Japanese bonds.

And even if these likely American austerity measures don’t result in an outright recession, job growth is already so feeble that most Americans still think we’re in recession.

Imagine how terrible things would feel if the economy slowed down even further.

5) Washington comes up with a deal to raise the debt ceiling that amounts to more than $4 trillion in savings, but over a longer-term horizon.

This is the best-case scenario: It deals with the long-term unsustainability of the country’s fiscal arrangements — which is good for growth in the long run — but doesn’t rock the boat in the current economic recovery.

Unfortunately, it also seems to be the scenario that is least likely to be pulled off effectively.

Economists want spending cuts and/or tax increases that come after 2012, when the economy is expected to be stronger. But to use Standard Poor’s lingo, cuts that take effect in 2012 may not be fully “credible.” Committing to future cuts/tax increases is just another way of kicking the can down the road, as Washington has been doing for decades now. Almost every time Congress promises painful fiscal measures at some future date, later politicians jump in to dismantle them just before they take effect.

“We do seem to have a time-consistency problem,” Mr. Maki said. “There does never seem to be a good time for major cuts, and they’re not going to be more popular five years from now versus now.”

He says that Congress must come up with a way to prove that these are cuts that will actually happen, versus something that’s on the drawing board and is therefore erasable.

Unfortunately, he says, “There is no way to completely tie the hands of future legislators.”

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