Josh Dowlut's  Instablog

Civil societies do not solve their differences through violent revolution. On the spectrum of violent chaos vs. orderly transition, failure to extend the debt ceiling would fall far beyond the middle line towards violent chaos.

What exactly would not raising the debt ceiling mean? It would mean an essentially overnight reordering of over 10% of the economy, the proportional size of the deficits that would have to cease. It would not mean a technical default on the full faith and credit guarantee of government issues debt, but it would mean a functional default on many other things, the only question is what other things.

“Mandatory spending” is roughly equal to tax revenue, so it is true that in addition to interest on the debt, you could also pay Social Security, Medicare, Medicaid, unemployment insurance benefits, and food stamps. However, that would require closing every other piece of the federal government, including the military, virtually overnight. File this scenario away under “impossible.”

Defense could be cut in half (a figure that would still leave us at inflation-adjusted end-of-Cold-War levels, and spending four times as much as the number two global spender China), and every other discretionary program could be cut in half. But that would require cutting 40% from the Social Security, Medicare, Medicaid, unemployment insurance, and food stamp category.

You cannot reorder more than 10% of the economy overnight and not have it leading to ketchup sandwiches and homelessness for some people. This point is not to be confused with whether you could cut federal government spending to 15%, or even 10%, without inducing ketchup sandwiches and homelessness. There are strong arguments to be made that roughly 10% of GDP is the optimal size of the federal government, but political brinksmanship where winning means a total chaos transition period is not the way to get there.

Similarly, you absolutely can cut government spending without hurting the economy. One of the many central flaws of Keynesian economics is the false notion that government is exogenous to the economy. Keynesian economics treats the federal government as if it were essentially a group of space aliens from another planet, completely outside the circle of the U.S. economy. According to Keynesian economics, the government has its own separate supply of scarce resources that it can add or subtract from the circle of the U.S. economy. This of course is not true. The private sector and the public sector both draw from the same factors of production of land, labor, and capital. The federal government’s income and demand role in the economy is no different from that of the combined role of an arbitrary group of U.S. corporations whose gross expenses would total up to the same figure as the Fed’s. Of course, if this group cuts back on its expenses, it has a short-term negative effect, but that cutback opens up room for other business to expand. Downwardly flexible prices are necessary for this to best function, but that is a topic for another time.

Americans enjoy a higher standard of living because of the faith the rest of the world puts in us. Part of that faith comes from having a very stable government, where regime change is an orderly process. Even if a technical default on the debt payments is averted (and it should be), the chaos, and even possible civil disorder that could come from this would be confidence eroding. You cannot turn a cruise liner on a dime without wrecking havoc to a lot of what is onboard.

Possible Federal Reserve solution:
Formally printing the debt

There's a theoretical solution that I have mentioned before in passing; I'll write it here to take credit for calling it if indeed it happens.

It is possible that the U.S. could continue spending as much as it does, without taxing anymore, AND without raising the debt ceiling. Such a maneuver would certainly be called “temporary and extraordinary,” but there has been a lot of that lately. All the debt ceiling means is that the Treasury Department cannot issue any new treasury notes to borrow any more money.

The Treasury Department is the country’s checking account. You deposit your paycheck into the checking account (tax revenue), and you pay all of your expenses out of the checking account (SS, Medicare, military, etc.). If your revenue is not covering your expenses, you use your overdraft protection. Now, the Federal Reserve is providing much of that overdraft protection by the fact that the Fed is buying a significant amount of the treasury notes being issued by the Treasury. There are primary dealers (big banks) involved as intermediaries (middlemen rent-seeking off the game, since mercantilist France, rich financiers have been getting richer by financing governments). Because of the intermediaries, it is not technically monetizing the debt. But what if we cut out all the middleman, and just plugged the Federal Reserve directly into the Treasury? In other words, what if Treasury did not have to issue notes, but could still get its money? Treasury and the Fed could work out some sort of internal agreement between the two of them, to not increase the external debt, or issue treasury notes. Functionally, it would be almost no different from what is already happening. The question is how the markets would respond to it. Given the precedent of what is already happening, and the expectations, it likely would be a less negative response than the abrupt reordering that would otherwise come with not raising the debt ceiling.

Such a move would be purely inflationary, and would have a similar welfare effect as a regressive consumption tax, but with less transparency. It is the fact that it is such a smoke and mirrors, paper-over-the-problems ploy that makes me think a switch from unofficially monetizing the debt to officially monetizing government spending is a leading contender for a final outcome of this.