Only in America: More Debt to Avoid Fiscal Meltdown

From the chaos of the Vietnam War came the oft-quoted paradox “we had to destroy the village in order to save it.”

It’s fair to ask if a similar version of that skewed logic is being applied to U.S. fiscal policy with regard to the debate over raising the debt limit from its current stratospheric level of $14.3 trillion.

The Treasury Department has warned that the U.S. will hit that limit by mid-May, which means that if Congress says 'no' to a higher limit, the government will not be able to borrow any more money to pay its bills.

So here’s the paradox: should Congress go ahead and approve raising the debt ceiling -- which it almost certainly will -- it essentially gives the government a green light to continue doing exactly what it did to dig the $14.3 trillion hole in the first place.

Fiscal hawks argue that by raising the debt limit -- for the eleventh time in 10 years, no less -- Congress will be sending exactly the wrong message and merely giving tacit approval for an already bloated government to go on spending money it doesn’t have.

At the same time, there is almost universal consensus that if Congress doesn’t approve the higher debt ceiling and the U.S. is faced with the very real threat of defaulting on its massive debt load, the fallout will be widespread and severe.

Treasury Secretary Timothy Geithner made that case to Congress in a letter earlier this year: “Failure to raise the limit would precipitate a default by the United States. Default would effectively impose a significant and long-lasting tax on all Americans and all American businesses and could lead to the loss of millions of American jobs. Even a very short-term or limited default would have catastrophic economic consequences that would last for decades,” Geithner wrote.

On those points at least there’s been very little dissension, even among staunch fiscal hawks.

“I think all of us understand that not meeting our debt obligations is a very bad idea and nobody wants to take that risk,” Speaker of the House John Boehner said at a press conference Wednesday.

Phillip Swagel, an economics professor at the University of Maryland and a former assistant secretary in the Treasury Department, agrees that the impact of the threat of a U.S. default would be “profound.”

“It could affect bond markets right away if participants believe the U.S government won’t make good on their debts,” said Swagel.

Rattled bond markets would lead to higher interest rates, and higher interest rates would threaten the already-fragile U.S. economic recovery.

But forecasts of financial Armageddon are premature and perhaps a bit hyperbolic, Swagel said. “It’s not a comfortable situation, but Treasury has a lot of flexibility and can prioritize the payments it makes just like a family does,” he said.

Realizing the political ramifications of appearing to do nothing about a runaway deficit, President Obama on Wednesday proposed a mix of tax increases and spending cuts designed, he said, to cut $4 trillion from the deficit over the next 12 years.

The President’s proposal, which includes cuts to defense spending and long-sacred entitlement programs such as Medicare and Medicaid, was apparently designed to appease Republican lawmakers who are demanding a concrete, long-term budget reducing plan in exchange for their votes to raise the debt ceiling.

Political posturing seems unnecessary, however, since nearly everyone agrees that any political benefits that might be gained by voting against a higher debt ceiling would be negated by the potentially devastating ripple effects of a U.S. default.

So just what is everyone afraid of?

Well, for starters all manner of government payments covering benefits, entitlements and contract obligations would be stopped, delayed or limited. That includes Social Security and Medicare, military salaries and retirement benefits, checks to veterans, federal employee salaries and pensions, individual and corporate tax refunds, unemployment benefits, payments to government vendors, including key defense contractors.

And so on and so on.

But perhaps the biggest fear is what the threat of a default would do to the U.S. reputation around the globe. If global investors who have used U.S. Treasuries as the safest of safe havens for decades suddenly fear the U.S., the world’s largest debtor nation, may not have enough cash to pay its debts the ripple effect could be catastrophic because those investors would also soon find themselves strapped for cash.

The result would be frozen credit market similar to what happened in 2008 and 2009, but conceivably on a much larger scale.

“Failing to service or redeem debt would lead to damage cascading through financial markets, as debt holders would be unable to meet their own obligations,” IHS Global Insight economists Nigel Gault and Gregory Daco wrote in a note to clients.

Indeed, many economists agree with Geithner’s assessment that the fallout from a U.S. default could at the very least lead to another recession and, in a worst case scenario, a fiscal crisis that far exceeds the recent global downturn.

The first significant ripple would be higher interest rates in the U.S. That would mean consumers would have to pay more for just about everything.

The interest rate on U.S. Treasuries is the benchmark rate for practically all other lending sectors. Consequently, if fears of a U.S. default drove the interest rate on Treasuries higher, the rates on all other loans would rise as well.

That would make it more expensive for state and local governments to borrow for capital projects, which would stall hiring and put another crimp in the U.S. recovery. Businesses would also find it more expensive to borrow for investment and expansion. And consumers would have to pay more for mortgages and car loans.

Higher interest rates would also bleed into the stock markets if companies forego expansion because it’s too expensive. If that happened, the stumbling labor market could collapse altogether, pushing the unemployment rate back toward the 10% mark.

Plunging stock markets, meanwhile, would mean another blow to the savings of retirement-age Americans, a demographic already battered by the recent financial crisis.

Internationally, the threat of a default would lump the U.S. into the same category as Portugal and Greece, two European countries that have seen their economies virtually wrecked as their governments have struggled to meet their financial obligations.

In other words, the U.S. has little choice but to raise the debt-ceiling. The IHS Global economists summed the situation up nicely. “It is hard to think of a bigger self-inflicted wound for a $10-trillion debtor than failing to service that debt.”