Today marks a crit­i­cal day in the bat­tle over the 2011 budget…the fis­cal year we’re already halfway through. Though the fed­eral gov­ern­ment has been kept alive via a series of Con­tin­u­ing Res­o­lu­tions, this Fri­day will be the end of the easy stuff. At the end of the day on Fri­day, the fed­eral gov­ern­ment will hit the debt ceil­ing of $14.294 tril­lion (about $46,000 for each res­i­dent of the US). With­out an increase in that debt ceil­ing, the fed­eral gov­ern­ment will be forced to choose between two options:

  1. Default on the debt
  2. Shut down major por­tions of the government

I’ll dis­cuss both of these shortly, but first…why is today the dead­line when we are still sol­vent until Fri­day? Because the House voted in new rules this year to have bills avail­able for pub­lic view­ing 72 hours prior to the vote. So if we don’t have a deal today, the options are vio­lat­ing that rule or choos­ing between the two above options at the end of the day on Fri­day. It’s pos­si­ble to stretch this out until Thurs­day, since a “shut­down” over the week­end will have min­i­mal impact, but that’s the absolute end of the line with­out vio­lat­ing the House rule.

So let’s look at the two options.

Default­ing on the debt would have a dis­as­trous effect on the US econ­omy. Assum­ing the US would be able to issue any addi­tional debt in the future, the inter­est rates for those bonds would be sub­stan­tially higher than they have been his­tor­i­cally. For the past cen­tury, there was no safer place to park money than in United States debt. This cer­tainty trans­lates into lower inter­est rates, because the reduced per­ceived risk leads lenders to feel no need for a risk pre­mium (in essence, a higher rate includes a vir­tual insur­ance pol­icy). If a default occurs, it will be at least sev­eral gen­er­a­tions before that risk pre­mium will disappear.

That higher per­ceived risk will also trans­late into a much weaker dol­lar, since the dol­lar will stop being used as the default (sorry) global cur­rency. Just as the US debt has his­tor­i­cally been con­sid­ered the safest place to park money, so, too, have dol­lars them­selves. The Euro­pean Union, who has taken great pains to avoid any defaults of their own debt, will most likely become the econ­omy of choice for safe park­ing, which would result in a dra­mat­i­cally stronger euro.

Rand Paul

Rep. Rand Paul (R-​​KY) (Image via Wikipedia)

Sadly, Rand Paul has been saber-​​rattling about default, even though it’s unclear how seri­ous he is about it. While such pos­tur­ing may be good pol­i­tics, it’s ter­ri­ble eco­nom­ics. It’s akin to going to the loan offi­cer and loudly announc­ing “Yeah, I might not bother pay­ing you back,” before even ask­ing for the loan. While I whole­heart­edly agree that the debt is a sub­stan­tial prob­lem and needs to be addressed with­out delay, it needs to be done with care and matu­rity. Paul is show­ing neither.

Shut­ting down the gov­ern­ment is barely a bet­ter option than default. Pre­sum­ing that such a shut­down lasts only a few weeks, the medium-​​term costs are likely to be sig­nif­i­cantly higher than sim­ply main­tain­ing the sta­tus quo. This arises because of the costs of breach­ing the mul­ti­tude of con­tracts in which the gov­ern­ment has already engaged. A shut­down of sev­eral months might recoup those costs, but the reper­cus­sions through the econ­omy would be cat­a­strophic. Gov­ern­ment activ­ity rep­re­sents approx­i­mately 20% of the GDP. For com­par­i­son, the frothy real estate mar­ket and its ancil­lary indus­tries (e.g., con­struc­tion), rep­re­sented just under 5% of GDP in 2007 and 2008. In other words, the impact can be expected to be about four times as great as the impact of the hous­ing bub­ble popping.

Of course, it’s not like the entire gov­ern­ment needs to shut down in order to main­tain sol­vency, so the amount of GDP impact will almost cer­tainly be less than 20%. For the entire 2011 fis­cal year, inter­est on the national debt rep­re­sents only $250 bil­lion, com­pared to the rev­enues of $2.23 tril­lion. That’s only about 11% of rev­enues devoted to ser­vic­ing the debt. The remain­ing 89% of rev­enues can still be spent, which would mean reduc­ing spend­ing by “only” 43%. So it’s not 20% of GDP; it’s 9%, which is still 1.8 times the amount that hous­ing rep­re­sented in the economy.

In other words, the impact is huge.

So, given the three choices of rais­ing the debt ceil­ing, default­ing on the debt, and cut­ting the fed­eral gov­ern­ment expen­di­tures by 43%, the first option has the low­est impact on the econ­omy, by far.

Repub­li­cans are caught in a tough spot right now. Many were elected on the promise of cut­ting gov­ern­ment spend­ing by $100 bil­lion from the 2010 bud­get (which would be $3.4 tril­lion). This was first walked back to a $100 bil­lion reduc­tion from Obama’s 2011 bud­get request (which would be $3.7 tril­lion, or a net increase from 2010 of $200 bil­lion). But even that far eas­ier num­ber seems unachiev­able, in light of a Sen­ate and White House still con­trolled by Democ­rats. What seems agree­able to many on both sides of the aisle is a cut of a lit­tle over $30* bil­lion from Obama’s orig­i­nal bud­get pro­posal, which ulti­mately nets about $270 bil­lion over 2010.

But can the House Repub­li­can lead­ers con­vince the Tea Party that a net increase of $270 bil­lion over 2010 is accept­able? It’s hard to imag­ine that it is, given the chants of “cut it or shut it” at the rallys. I fear that the over­all impact of a shut­down is under-​​appreciated by those with a more ide­o­log­i­cal bent.

Paul Ryan isn’t exactly help­ing by talk­ing big (four tril­lion dol­lars in cuts), while avoid­ing the small-​​print real­ity (it’s over ten years, almost entirely back loaded, and his pro­posal makes a ton of barely cred­i­ble assumptions).

That’s not to say that we shouldn’t be address­ing the national debt; we should. But the respon­si­ble way to do it is by draw­ing it down when the econ­omy is healthy, and to do so in a way that is rel­a­tively gen­tle and pre­dictable. Ide­o­log­i­cal rant­ing and chant­ing does noth­ing to help us achieve that goal.

*In an ear­lier ver­sion of this arti­cle, the num­ber was erro­neously listed as $300 bil­lion, not $30 billion.

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