Hearing on Risks of Default to the U.S. Economy and Jobs

Posted on by Karina

This afternoon, Leader Pelosi and the House Democratic Steering and Policy Committee are holding a hearing on how a default on the debt would impact our economy, job creation, seniors and the middle class. As Bruce Bartlett, Former Advisor to Presidents Ronald Reagan and George H.W. Bush, explains in his prepared testimony:

Indeed, there are those within the Republican Party who genuinely hope for default, believing, insanely in my opinion, that somehow or other this will benefit the American people…The point I am making is that there is a long tradition of advocacy for debt default and even repudiation among conservatives and Republicans. While once these might have been considered fringe views, it is clear that they are now mainstream among those in the Tea Party, who dominate Republican primaries and hold virtually every Republican in Congress hostage to its demands, no matter how ridiculous or extreme…

Republican political gamesmanship is putting our economy at risk and the witnesses will speak to the real consequences for the middle class. As Professor Matthew Slaughter in prepared testimony explains, “the damage facing the American labor market today, in terms of both jobs and incomes, is difficult to overstate.” Potential consequences include:

Stock prices could fall, taking a direct hit on families’ 401(k)s, pensions, and savings

Housing prices could drop and home sales could plummet

Social Security checks could be withheld and massive numbers of federal workers could be furloughed

Lower-income families would foot the bill, as interest rates rise and their debt payments increase

This hearing is the only one in the House of Representatives on this critical issue with bipartisan witnesses including advisers to President Reagan, President George H. W. Bush, and President George W. Bush:

Bruce Bartlett, Columnist, Former Advisor to Presidents Ronald Reagan and George H.W. Bush

Alan S. Blinder, Professor of Economics and Public Affairs at Princeton University, Co-Director of Princeton’s Center for Economic Policy Studies

Heather Boushey, Senior Economist, Center for American Progress

Matthew J. Slaughter, Associate Dean of the MBA Program and the Signal Companies’ Professor of Management at the Tuck School of Business at Dartmouth, Former Member on the Council of Economic Advisers under President George W. Bush

Read excerpts from prepared testimony:

Bruce Bartlett:

I think those who believe the Treasury can easily avoid a default by prioritizing its payments – which it already has the authority to do under a 1985 General Accounting Office opinion – don’t understand how variable its cash flow is. Inflow almost never matches outflow on a daily or even monthly basis.

The leading authority on the Public Debt Clause is Prof. Michael Abramowicz of the George Washington University law school. In a 1997 law review article, he discussed the history and interpretation of it at length. Abramowicz’s conclusion is that any government action “making uncertain whether or not a debt will be honored is unconstitutional.” As he explains:

A debt does not become valid or invalid only at the moment payment is due. A debt’s validity may be assessed at any time, and a debt is valid only if the law provides that it will be honored. Therefore, a requirement that the government not question a debt’s validity does not kick in only once the time comes for the government to make a payment on the debt. Rather, the duty not to question is a continuous one…

…To my mind, this means that the very existence of the debt limit is unconstitutional because it calls into question the validity of the debt…I conclude that should the debt limit become severely binding – threatening not just interest or principal repayments on the debt, but any other payment that could reasonably be construed as a debt – then the Treasury would be justified, as a matter of constitutional law, to disregard the debt limit and do what is necessary to raise the cash needed to avoid default on any of its obligations.

Obviously, it would be highly undesirable to provoke a constitutional crisis over the debt limit and it should only be contemplated under the most dire circumstances, which I for one would certainly not wish to occur. Unfortunately, there may be no alternative. Any number of Republicans in Congress have said publicly that they will not vote to increase the debt limit under any circumstances, and some senators have said they will filibuster any increase passing the House. Others have said they will not vote for a debt limit increase unless extremely unrealistic conditions are met, which means that they would likely join a filibuster. Even if cloture is invoked, a filibuster could well delay a debt limit increase past the point where default would occur.

A debt default and a constitutional crisis are both unpalatable options, unthinkable under ordinary circumstances. But these are not ordinary circumstances. It is clear that one of our major parties is now gripped by a sort of insanity that compels it to act in a way that is extremely detrimental to the well-being of all Americans, themselves included. We know from history that when threatened by such dire political circumstances, presidents such as Abraham Lincoln and Franklin D. Roosevelt took actions that went well beyond generally accepted constitutional bounds. The verdict of history, however, is that they acted appropriately and are rightly considered among our nation’s greatest presidents.

I would like to close with a quote from Ronald Reagan, whom many of those threatening default claim to revere. Said Reagan in a 1983 message to the Senate:

This country now possesses the strongest credit in the world. The full consequences of a default – or even the serious prospect of default – by the United States are impossible to predict and awesome to contemplate. Denigration of the full faith and credit of the United States would have substantial effects on the domestic financial markets and on the value of the dollar in exchange markets. The Nation can ill afford to allow such a result.

Alan S. Blinder

Although federal outlays and receipts vary greatly from day to day, on an average day in fiscal 2011,outlays exceed receipts by more than 40%. That stunning number indicates how far the budget is out of whack. But it’s also the current law of the land. If the government loses its ability to borrow, spending will have to fall more than 40% instantly. If default on the national debt is to be avoided, the decline in non-interest spending will have to be even larger. In dollar terms, we are talking about roughly $1.6 trillion at annual rates, or more than 10% of GDP. I don’t see how we could avoid a relapse into recession with a spending cut of that magnitude.

And this back-of-the-envelope calculation does not even allow for the impact of the financial panic that would likely ensue. The magnitude, timing, and details of such a panic are all unpredictable—which, to me, makes them scary. Indeed, what makes them even scarier is that markets have convinced themselves that it will never happen—that the U.S. government would never do anything that stupid. If they are proven wrong, they’ll be shocked. And shocked markets tend to be panicky markets. Interest rates will surely rise–and not just on Treasury debt. But no one knows how much. The dollar will almost certainly fall. But no one knows how far. The stock market will tank. But no one knows how deeply…

The longer-term impacts are just as unpredictable. We know for sure that the creditworthiness of the United States government would be damaged. Even if the default was cured quickly, markets would learn that politically-induced default was now a weapon in the U.S. political arsenal. The world would lose its ultimate safe haven.

Heather Boushey

…If the debt ceiling is hit, spending reductions could take a variety of forms, from withholding Social Security checks, to furloughing massive numbers of federal workers, to not paying government contractors in Iraq and Afghanistan. It’s almost shutting down the government.

Reaching the debt ceiling will, in all likelihood, trigger a sharp fall in the stock market. The drop in stock prices will have an immediate effect on the economy, but also on families. Families with 401(k)s would likely lose all the gains they have made in 2010 and much of their gains in 2009, moving them further below where they were at the end of 2007 after the stock market fell sharply. This is magnified by the fact that the very first of the baby boom generation—the largest generation thus far in U.S. history, and the first generation where a majority (near 60 percent) will retire with 401(k) rather than pensions—is now retiring.

Both immediately and down the road, bondholders will likely require higher interest rates on U.S. Treasuries. This in and of itself will increase the deficit as the interest the federal government pays on its debts will rise as old debt is turned over into new bonds. Third Way estimates that “bond rate increases alone would eliminate nearly 650,000 jobs in the United States.”…

Lower-income families would quickly see their debt payments go up in the wake of higher interest rates. Lower-income families are more likely to owe adjustable interest rate debt, such as credit cards, installment loans, and adjustable rate mortgages. If the treasury rates immediately go up by 0.5 percentage points, the household debt service burden for the average U.S. family would also increase by at least 0.5 percentage points, an amount that is larger than the increase in the amount spent on gasoline for that same family from the fourth quarter of 2010 to the first quarter of 2011.

The U.S. housing market would most likely experience a severe double-dip contraction marked by much lower home sales and depressed house prices. Mortgage interest rates typically rise more than U.S. Treasury rates. A debt default would likely cause an increase in the 10-year Treasury rate by half a percentage point, which could translate into a jump in the mortgage rate equal to 0.66 percentage points, the highest levels since 2008. This will further depress the housing market.

Matthew J. Slaughter

If America defaults, the first and potentially most catastrophic impact will be on U.S. and global capital markets. I implore you to understand that America is tempting a financial crisis of unknowable proportions if we default on our Federal government debt…

Fiscal crises have often come sharply and with little warning. All is okay; all is okay; all is okay. And then, one day, all is catastrophically not okay. Markets are not omniscient; neither are the academics, investors, and policymakers that scrutinize markets. Low interest rates today do not preclude high interest rates tomorrow. And because of the unique role U.S. Treasurys currently play as the world’s risk-free asset, the widespread yet immeasurable demand for Treasurys (for many short-term—e.g., collateral—and long-term—e.g., institutional investors mandated to hold certain “safe” assets—uses) means no one really knows what a default would do to Treasurys and to the world more generally. Discovering these answers via default would be foolhardy at any time. Today with all the ongoing fragility in the global financial system, the prospect of default is truly frightening.

If America defaults, a second and potentially major impact will be on aggregate demand and output. Default risks throwing America back into recession by reducing investment spending by businesses and consumption spending by households…

A spike in Treasury interest rates sparked by default would, in turn, boost interest rates throughout the U.S. financial system. Businesses looking to borrow to fund new property, plant, and equipment investment would face higher prime interest rates from banks and higher corporate-bond rates from broader debt markets. In turn, higher borrowing costs would reduce some planned capital investments. Similarly, households looking to borrow would face higher mortgage interest rates for home purchases, higher bank interest rates for durables purchases like automobiles, and higher credit-card interest rates for all kinds of goods and services…

If America defaults, a third and also potentially major impact will be on American jobs and wages. Default risks further harming scores of millions of American workers and their families who have been facing years and, in many cases, decades of no labor-market improvement. The damage facing the American labor market today, in terms of both jobs and incomes, is difficult to overstate…

The bottom line is that today the typical American compared to a decade ago is earning less income amidst fewer overall jobs. Economically, America’s labor market has lost a decade. All sensible forecasts are that it will take several years of economic growth for the American labor market to fully recover the number of jobs it had before the start of the Great Recession. When incomes might recover is far harder to forecast.

But all these forecasts are predicated on no major financial or economic crises recurring. If America defaults on its debt and thus sparks some sort of new financial crisis and/or recession, America’s workers and their families will surely suffer further job losses and income declines.

Let me conclude by stating that America’s fiscal challenges are grave. We need the understanding of our creditors—domestic and, increasingly, foreign—to overcome these challenges. As such, America should be doing everything in its power not to cast doubt on the pledge to honor our debts…

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