Special topics in calamity economics

By R.A. | WASHINGTON

OVER the past week, there has been an uptick in fretting over the outcome of the debt-ceiling negotiations. House Republican Eric Cantor bailed on the negotiations, and a spate of public sniping broke out, generating fears that Republicans and Democrats are farther from an agreement than had been imagined. Bargaining has now been kicked upstairs to the president, who will meet with Senate leaders to try and hash out a deal.

In the current issue of The Economist, there is a rather disheartening look at just what might happen if talks fail. The distressing answer is that no one really knows, but that financial market havoc is almost sure to result. In a May post here at Free exchange, a colleague wrote that in the event of a temporary breach of the limit, the government would likely opt for immediate, massive cuts in order to prevent an outright default. Quite apart from the financial market implications, that would represent a hugely contractionary force on the economy, probably sufficient to send it back into recession. And in the case of actual default? Keep in mind that investors around the world have gobbled up American debt in recent years as a safeguard against trouble elsewhere. If that rock of safety suddenly became vulnerable, well, September of 2008 would probably look like a picnic in comparison.

My operating assumption has long been that the debt ceiling will be raised. The potential cost of a failure to do so is just too large for either party to tolerate. And despite the recent ructions, I still think that an increase in the ceiling is likely. But I think it's fair to say that the odds of some kind of "default", while quite low, have risen a bit.

This could potentially be a problem. Markets try to prepare for trouble. If there's a chance of bad times ahead, market participants will take precautions, just in case. They may move money to safer assets, increase cash holdings, curtail marginal investments, put off hiring, and so on. Do you see the problem? These sensible measures are themselves bad for the economy. Now, the probability of an actual default isn't very high. But the cost of default is catastrophic. So even if the odds of default shift from very small to slightly less small—from say 2% to 5%—that shift represents a substantial increase in the potential economic downside looking forward. And that, in turn, could lead to greater precautionary measures from banks, businesses, and households.

Because failure to raise the debt ceiling would be so nasty, that very possibility could cause serious economic damage even if the odds of an actual default never approach 50%. This, once again, is why Congress should tread extremely cautiously. Its only responsible course of action is to pass an increase in the debt ceiling without any further delay, and certainly without any further dramatics.