Train Wreck: Consequences of a Government Shutdown

The economic consequences of a government shutdown can't be calibrated on a spreadsheet with an economic model. It all depends on who wins public opinion -- Congressional Republicans or the President and Democrats.

Federal spending is out of control. From 2007, the last full year before the financial crisis, to 2011, the second full year of economic recovery, spending has jumped $1.1 trillion -- 40% -- when a $200 billion increase would have satisfied inflation.

For any other country, a deficit exceeding 10% of GDP would force austerity by sending interest rates on government bonds through the roof. Alas, the United States prints the world's currency -- the dollar -- so it can inflate its way to solvency, and the bond market is starting to take that bet.

Enter the Tea Party, that troublesome bunch of youngsters pushing elder Republicans to stand up for fiscal solvency, end the madness or halt funding for the government.

Closing federal offices for a few days will have not a great, lasting impact. On reopening, the checks will go out. What counts, though, is whether the newly elected conservative majority in the House of Representatives keeps its mandate as measured by the polls.

Through 2012, the projected cumulative deficit is $11 trillion, and House Republicans are crafting a plan to cut that figure by $6 trillion. The means are hardly attractive -- vouchers for poor folks to purchase health care and block grants to the states to replace and reduce much of federal Medicare spending. That would morph President Obama's vision of universal coverage into a victimization plan for the poor and even bigger budget crises for the states.

Americans pay too much for health care, spending 18% of GDP for less effective service than the Germans and Dutch receive spending only 12%. Instead of taking on higher U.S. drug prices, bloated health insurance and hospital administrative costs, and malpractice abuse, Republicans will tell the poor and the states to bargain with the big guys directly -- good luck with those ideas.

As for Social Security ... hush, Republicans have a secret plan! The GOP will save money but so far has not revealed how. Private investment accounts, the favorite among free marketers, would leave brokers smiling but the old poorer, judging by how most IRAs have faired since 2000.

If the President comes out of the government shutdown politically stronger, then it's business as usual, but can it be?

Thanks to huge deficits, inflation expectations are rising, and bond investors are becoming wary that the secular trend on 20 and 30 U.S. Treasury rates is up and up. Not just a cyclical adjustment this summer, as unemployment falls and the Federal Reserve ends quantitative easing, but up and up over the next several years because the size of deficits President Obama's budgets project are on the low side. He assumes too much cost savings and additional revenue from health-care reforms and a 4% growth rate for the next four years few economists would endorse.

As the long rate on Treasuries rises, interest payments will absorb more and more federal revenue, and austerity will be hoisted on the U.S. government in the manner of Greece or Portugal. At the point, slashing as opposed to reason will prevail. Thoughtful reforms in health care and for Social security become even more difficult.

It's tough to forecast the consequences of a fiscal train wreck; but if the Democrats win the day in a government shutdown, it only postpones the inevitable reckoning to an ultimate day of calamity.

The choices are clear. Responsible reforms to health care that harness drug, administrative and tort costs now, and ensure solvency for Social Security by raising the retirement age to 70, or the bond vigilantes will ultimately end the party. Changes more Draconian will be forced on the American people who simply refuse to live within their means.

Peter Morici is a professor at the Smith School of Business, University of Maryland School, and former Chief Economist at the U.S. International Trade Commission.