Arnold Kling  

The Alternate Universe Problem

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Megan McArdle writes,


If the GOP doesn't cut a deal sometime pretty soon, we're either going to default on our debt (hello, financial crisis, unemployment spike, substantial and immediate drop in GDP, followed by an angry mob of voters descending on their polling places with pitchforks), or we're going to cut a bunch of programs that beneficiaries are very attached to. (Hello, angry mob of seniors descending on their representatives with machetes.) There is no deal that they can cut which does not include raising more revenue; the Democrats aren't going to be the only people offering compromise, and I don't blame them.

She agrees with David Brooks. A couple of months ago, I called this the Alternate Universe Problem.

If I were making Republican strategy, I would be trying to get a Simpson-Bowles package. My thinking is that if the Republicans want deeper spending cuts than that, then they have to win some more elections.


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COMMENTS (23 to date)
Tyler In Chicago writes:

What no one seems to notice is that default is the ultimate way to "starve the beast". Cutting taxes didn't work because policy-makers turned to borrowing and jacked up spending anyway. But defaulting on the debt is a twofer - it raises interest on the debt, taking money away from social programs today and in the future, locking in beast starvation for decades.

That, I believe, is the answer to Megan's question in her follow-up post:

"Based on the argument that the Democrats will get everything they want if we default (Obama re-elected, more Democrats in Congress, higher taxes, more programs), why would they (Democrats) settle for anything less than default?"

Chris Koresko writes:

Megan McArdle: If the GOP doesn't cut a deal sometime pretty soon, we're either going to default on our debt (hello, financial crisis, unemployment spike, substantial and immediate drop in GDP, followed by an angry mob of voters descending on their polling places with pitchforks), or we're going to cut a bunch of programs that beneficiaries are very attached to.

I wonder how credible this scenario actually is. If we really did stick to the current debt cap, that would imply that spending, including interest on the debt, would have to drop to the level of current revenue, correct?

But how does that imply the choice between default or massive cuts to popular programs? If I understand correctly, the debt interest is something like $200B which is a small fraction of revenue. So the incentive to default looks very small compared to the likely consequences.

On the other hand, it strikes me that quite large spending cuts could be made without much direct or immediate impact on most individuals. Close or drastically shrink most regulatory agencies. I'm thinking of the Dept of Education, the FDA, Dept of Agriculture, Interstate Commerce Commission, Amtrak, ethanol and farm subsidies, etc., etc.

I'm not sure if enough of that stuff could be found to close the whole deficit. But the result of those cuts ought to be an economic boom, at least if a claim I've heard recently is true (that each federal regulator costs close to 100 private-sector jobs and some millions of dollars of GDP). Such a boom would shrink the cost of social programs and boost revenue, right?

N.B. McArdles's claim of a GDP drop is based on a pure Keynesian model that assumes that GDP is directly linked to the federal deficit, right?

Matt C writes:

What Chris said. Interest on the debt is a small fraction of revenue. We do not have to increase our credit limit to keep making our existing debt payments.

I thought it was dishonest when reporters started equating not raising the debt ceiling with default on the debt. Now everyone is doing it, every time the debt ceiling is discussed.

I don't understand this. Why isn't anyone challenging this equivalence, even parenthetically, even in passing?

david nh writes:

But isn't cutting "a bunch of programs that beneficiaries are very attached to" the whole point? Just how do the Megan McArdles and David Brooks think fiscal sanity will be restored - by locking in bigger government through higher taxes? Did that work before?

Option 1: act like grownups now (semi) voluntarily and with the luxury of some time to manage a transition.

Option 2: be forced to act like grownups later, precipitously and with much more disruptive effect.

Raising taxes will work just like the stimulus worked, i.e., not. When you are on the wrong side of Laffer Curve optimum, in a world of massive regime uncertainty, raising taxes will be disastrous.

I would have thought the US was well beyond the point where we had the luxury of engaging in political calculation (a la McArdle's point above).

david nh writes:
My thinking is that if the Republicans want deeper spending cuts than that, then they have to win some more elections.

Didn't they do that already? How many do they have to win?

Mercer writes:

"My thinking is that if the Republicans want deeper spending cuts than that, then they have to win some more elections.
Didn't they do that already? How many do they have to win?"

They won an election on the message that any cut to Medicare=death panels. They passed a budget that only starts to cut Medicare in ten years. They recently passed on the chance to cut funding for the unpopular war in Libya. If they will not vote to defund an unpopular war why should they be taken seriously when they say they are for cutting spending?

The GOP controls the House. If they want big spending cuts they can pass big spending cuts this year. The GOP's problem is they want to cut taxes but they do not want to cut spending on old people or on the military.

John Thacker writes:
They recently passed on the chance to cut funding for the unpopular war in Libya.

Technically, a strong majority of Republicans voted to cut the funding; the funding was saved by most Democrats voting for it. Republicans were 144-89 to block the funding; Democrats were 36-149 in favor of funding.

If they want big spending cuts they can pass big spending cuts this year.

What they're asking for in the debt limit negotiations is the same thing in the budget that they passed-- big spending cuts phased in over ten years. By that standard, they did pass a budget with big spending cuts-- and the Democrats refuse to cut it.

I too wish that the Republicans would want to cut spending on old people and the military-- but it's not as though the Democrats are one jot better on that score.

david nh writes:
If they will not vote to defund an unpopular war why should they be taken seriously when they say they are for cutting spending?

Neither the GOP or the Democrats will be taken seriously unless they actually cut spending. Simply talking about cutting, regardless of what area one talks about won't do the trick. Investors and financial markets (domestic and foreign) will not take the US seriously unless it demonstrates some will to cut expenditure now, not just in the future, and to do so to some non-laughable extent.

My point was that cutting spending in areas in which there are powerful constituencies, whether old people, bureaucrats or those that support the military, is unavoidable. Getting out of the fiscal mess without upsetting all sorts of people, at least in the short run, is not possible. Unfortunately, that's what happens when everyone tries to live off everyone else, to paraphrase Bastiat. Sooner or later, you run out of other people's money (as Margaret Thatcher noted).

mike shupp writes:

The GOP's problem is that the House can pass tax cuts and decree spending cuts in Medicare, Medicaid, Social Security, etc. but that the Senate will not necessarily go along.

I suspect Republican congressmen contemplating default on the debt have two ideas on their minds: that the need for immediate action will spook so many Democrats that Republicans will be in control of the post-default budget cutting, and that Republicans will be able to successfully blame Democrats for the size of the cuts and the pain felt by voters ("We just wanted a tiny little 100 billion dollar cut in unnecessary waste; thanks to stalling and lack of cooperation by the Democrats, we've had to make 300 billion dollars of cuts, and It's All Their Fault!").

They're probably wrong on the first point -- I expect the US armed forces to lose at least one infantry division this year, one AF fightter wing, and one carrier battle group. We'll see how the second point fares next November.

Brian Clendinen writes:

Megan McArdle is an absolute idiot if she thinks not raising the debt ceiling is equal to default.


The Treasury will have decide who to pay and in what order once we reach the ceiling. Someone is not going to be getting checks from the government in a timely manner. That is not default, that is late payment. It will not be debt holders, I doubt it will be social security, soldiers, or congress. Most likely will be grants, payments to states, defense contractors ect.

The lesson is if you are mostly dependant on the federal goverment for cash, make sure you have enough to operate for a few months. You are going to get paid, it is just might take a while.

I hope congress is the one who lays out the payment priorities but the Democrats might not bit and let Obama run the payment priority show.

I would love to see Congress not allowing the EPA, Department of Housing, Department of Education, all TARP & stimulus recipients get no money until 100% of all obligations to everyone else is paid. Which would mean no money for them until the debt ceiling is raised.

Unfortunately that is just an fancy dream of mine. My top pick for no funding right now would be TSA but still require on-time flights. However, that is not going to happen.

It is a crap shoot, I have no idea how this will play out.

MikeDC writes:

My understanding is that without raising the debt ceiling the government will default because it will not have the cash on hand to pay back maturing treasuries (not simply interest payments).

The personal equivalent is someone having a balloon payment at the end of a 7 yr arm. Paying the interest isn't a problem, but you have to go out and get a new mortgage in order to pay off the big ending payment. The USG has $14t of debt, and something like $2-3t of it is due in a year. That, of course is greater than or equal to the tax revenue than we generate in a year, so if we have to refinance or we'll default. And it would be a big deal.

MikeDC writes:

Now, as to what should be done, were I a Congressman, I would offer Authorize raising the debt ceiling over the next year on only a dollar for dollar basis to pay off maturing debt and stabilize the payment structure over a longer term such that it may well be possible to refuse to authorize another increase down the road without catastrophic results.

While that doesn't solve the long term structural deficit problem, it retains it as a useful political tool for reducing spending while making it less dangerous.

Dan Weber writes:

If we really did stick to the current debt cap, that would imply that spending, including interest on the debt, would have to drop to the level of current revenue, correct?

No, because tax increases come back as a possibility. You might think you've finally stopped taxes and stopped borrowing, but like sticking your thumb into a firehose, there is tremendous pressure in there.

it strikes me that quite large spending cuts could be made without much direct or immediate impact on most individuals

Please look at the budget. DoE (either of 'em) aren't even rounding errors.

Social Security, Medica[re|id], and Defense are the big players. You have to address them if you want to cut spending. And even assuming a 50% cut in Defense will only buy you a few years.

You have to cut things people like. If no one liked those programs they would have been killed a long time ago. Those programs are extremely popular, for better or for worse.

Matt C writes:

MikeDC, that makes sense. Thanks for shedding some light on something that has seemed weird for a long time.

Matt C writes:

Well, having to roll over 20% of your national debt every year does not make sense. But the idea that not rolling it over makes a huge mess does.

8 writes:

Except that not raising the debt ceiling doesn't stop you from rolling over maturing Treasuries. The argument that not raising the debt ceiling will lead to default is like saying if you stop opening new credit cards after you max out all your other cards, you will default. It's complete and utter nonsense.

Another total moronic theory floating around is that the dollar will weaken if the debt ceiling isn't raised.

I understand why Geithner peddles these lies, but I don't know what's the excuse for the rest of the political-media complex.

Matt C writes:

I can believe that rolling over 2.5 trillion in a 14 trillion budget could make for a tricky cash flow problem. I am not saying we *must* default if we don't raise the debt ceiling. But if we assume entitlements are off the table (and they are, at least for now) then keeping all the balls in the air is a little harder problem than I thought.

MikeDC writes:

8,
If the only way you have to pay the minimum balance on your existing card is to open a new one, then yes it does.

The debt ceiling effectively says your existing cards are maxed out and you can't open a new one.

Unfortunately I think the magnitude of debt we owe is bigger than our income. I haven't yet refreshed myself on the cash flows, however, and that's a major detail. The Treasury generally takes in something like $175B/month in revenues. (about $2.1T).

Thus, if we were only talking about $20B per month of maturing debt, you'd be exactly right. However, if we're talking about $200B per month of maturing debt, the Treasury could direct every penny it receives to the maturing debt and still not be able to cover it. And I think that number is closer to right than $20B.

However, I have heard the argument floated that the Treasury could do dollar for dollar re-floating of maturing debts even if it hits the ceiling, since typically treasury brokers (and the govt, importantly) don't clear these transactions till then end of the day). Thus, the govt could, in essence, borrow $200B in the morning to pay off the $200B due by COB. According to the accounting rules in use (government accounting, awesome!) apparently this wouldn't count as exceeding the debt limit.

Still, it's cutting things close, and while it somewhat counts as "shenanigans" in my book, it's also likely a way out. My personal guess is that the President would prefer a calamitous default, but I hope to be proven wrong.

8 writes:

If $200 billion in bonds mature and Treasury issues $200 billion in bonds, the debt ceiling is not breached. China alone will want to buy much of the rolling debt, not to mention the rest of the market.

Where the rubber hits the road is that the deficit is over $1 trillion. USG will immediately be operating on a balanced budget and spending will collapse if the debt ceiling isn't raised. The same way it did for families who had to sell their homes and slash spending during 2008-2009.

quadrupole writes:

Simpson-Bowles is only realistic if you can explain how you are going to escape Hausers Law. Simpson-Bowles presumes you can jack revenue above 18% of GDP reliably overtime... and unless you can explain to me magically what you are doing that you didn't try over the last 64 years... well... I don't believe you.

Note: Things I'd be inclined to believe might do it would be a VAT (which I opposed). But that at least hasn't been tried before as a means to escape Hausers Law.

kurt writes:

@MikeDC
Less than $100 billion a month on average for bonds if I read (http://www.treasurydirect.gov/govt/reports/pd/mspd/2011/2011_may.htm) correctly. Even dealing with treasury bills, they should be able to handle this, not?

Dan Weber writes:

Here is a recent budget for the US:
http://en.wikipedia.org/wiki/File:2010_Receipts_%26_Expenditures_Estimates.PNG

First, realize that getting rid of stuff like the Dept of Agriculture isn't going to fix the problem. Not that I think the DoA shouldn't go away for many reasons, but it and all its siblings aren't going to fix it.

Second, imagine the government can't borrow, and look at the list of things on the right. If Congress is paralyzed all the mandatory spending still happens (that's the definition of mandatory), but you've only barely balanced the budget, along with stranding all the overseas troops.

Simpson-Bowles presumes you can jack revenue above 18% of GDP reliably

From about 1977 to about 2002 the revenue was at or above 18% of GDP for about 99% of the time. Wolfram|Alpha

Reliably staying above 19% (with income taxes) is hard, but being above 18% not so much.

Seth writes:

"My thinking is that if the Republicans want deeper spending cuts than that, then they have to win some more elections."

Maybe.

But I think these Republicans don't feel they will win more elections unless they hold tight with reversing the government ratchet.

They may be wrong. We'll see.

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