At the NBER meetings, I have been asking around what will happen if the Federal government defaults, and Treasurys go down a notch in ratings. Keep in mind pension funds and financial institutions are constrained to hold at least some AAA rated securities. What happens if those securities are downgraded; should we expect a smooth, re-balancing of portfolios worldwide?
Jeff Frankel dissects why we are in this situation, using fable (well, a movie fable):
In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken. Both intend to jump out at the last moment. But the other guy miscalculates, and goes over the cliff with the car.
This is the game that is being played out in Washington this month over the debt ceiling. The chance is at least 1/4 that the result will be similarly disastrous.
The game is not symmetric. The Republicans are the ones who are miscalculating. Evidently they are confident of prevailing: they rejected the President’s offer, even though he was willing to cut entitlement programs.
The situation is complicated because there are a number of different people crammed into the Republican car. There is one guy who is obsessed with the theory that, come August 3, the federal government could retain its top credit rating if it continued to service its debt by ceasing payment on its other bills. But this would mean failing to honour legal obligations that have already been incurred … This is like observing that the cliff is not a 90 degree drop-off, but only 110 degrees. It doesn’t matter: the car would still go crashing into the ocean far below. The government’s credit would still be downgraded and global investors would still demand higher interest rates to hold US treasuries, probably on a long-term basis.
There are other guys (and gals) in the car who are even more delusional. They are dead set on a policy of immediately eliminating the budget deficit (e.g., those opposed to raising the debt ceiling no matter what, or those campaigning for a balanced budget amendment), and doing it primarily by cutting nondefense discretionary spending. This is literally impossible, arithmetically. But they honestly don’t know this. It is as if they were insisting that the car can fly. Sometimes it can be a good bargaining position to adopt a very extreme position. But if you are demanding that the car flies, you are not going to get your way no matter how determined you are.
It seems likely that the man in the driver’s seat – House Speaker John Boehner – does realise that his fellow passengers don’t have the facts quite right. But there is also a game of chicken going on within the Republican car. The crazies have said they will oppose in the next Republican primary election any congressman who votes to raise the debt ceiling or to raise tax revenues.
On a related point, here is the position of one of the drivers listed above.