Sunday, July 17, 2011

Is A US Default Is A Good Thing?

Over on my political blog, I've been writing in partisan terms about the current standoff between the GOP-controlled House and the president regarding the soon-to-be-reached US debt limit.

In this post, I'm going to attempt to be non-partisan, and, instead, engage in a thought experiment concerning the US debt limit and default.

Everyone seems to believe that a real US default would be bad. Two months ago, I wrote this post discussing Stanley Druckenmiller's weekend interview in the Wall Street Journal. He contended,

"A financial crisis is surely going to happen as big or bigger than the one we had in 2008 if we continue to behave the way we're behaving," says Stanley Druckenmiller, the legendary investor and onetime fund manager for George Soros. Is this another warning from Wall Street that Congress must immediately raise the federal debt limit to prevent the end of civilization?

No—Mr. Druckenmiller has heard enough of such "clamor and hyperbole." The grave danger he sees is that politicians might give the government authority to borrow beyond the current limit of $14.3 trillion without any conditions to control spending.

"I think technical default would be horrible," he says from the 24th floor of his midtown Manhattan office, "but I don't think it's going to be the end of the world. It's not going to be catastrophic. What's going to be catastrophic is if we don't solve the real problem," meaning Washington's spending addiction.

"Here are your two options: piece of paper number one—let's just call it a 10-year Treasury. So I own this piece of paper. I get an income stream obviously over 10 years . . . and one of my interest payments is going to be delayed, I don't know, six days, eight days, 15 days, but I know I'm going to get it. There's not a doubt in my mind that it's not going to pay, but it's going to be delayed. But in exchange for that, let's suppose I know I'm going to get massive cuts in entitlements and the government is going to get their house in order so my payments seven, eight, nine, 10 years out are much more assured," he says.

Then there's "piece of paper number two," he says, under a scenario in which the debt limit is quickly raised to avoid any possible disruption in payments. "I don't have to wait six, eight, or 10 days for one of my many payments over 10 years. I get it on time. But we're going to continue to pile up trillions of dollars of debt and I may have a Greek situation on my hands in six or seven years. Now as an owner, which piece of paper do I want to own? To me it's a no-brainer. It's piece of paper number one." "

I think Druckenmiller is correct, and generally on the right track.

Suppose the GOP has dug in its heels and will only raise the debt limit with associated, larger spending cuts, and the Senate won't pass such a bill. Or, if it does, Obama won't sign it, daring Congress to allow a government shutdown.

We've all had the last week's worth of presidential press conferences to digest, let's take Obama at his word- that he will tell Geithner to stop writing any checks whatsoever if the debt limit isn't raised.

I think this would actually be a good thing. But to believe it, you have to also believe, as Druckenmiller does, that US fiscal policy for the past few decades has been seriously wrong. That running chronic large deficits since the 1930s has become a habit that cannot be sustained for more than the next few years.
Druckenmiller contends that no serious change at all in federal spending and disposition regarding its habits would be the worst outcome. And if the GOP rushes to capitulate after a government shutdown, there won't be such change. Obama will declare political victory, many Tea Party voters will be disgusted with the GOP.
But if Obama faces a GOP House whose members are willing to force a shutdown and, then, after it is clear there won't be capitulation, an ordered payment of federal obligations, while some functions are shuttered, everyone- global investors, voters, onlookers- will understand that things have changed.
In the meantime, the US would have lost its AAA rating. No matter which party gained relatively greater power among Congress and the White House in 2012, a return to borrowing and spending for new programs would no longer be an option. Interest rates would be too high on Treasuries to borrow much more money, if investors would even lend it. Slow economic growth and joblessness would make higher taxes on anyone a non-starter.

In short, a default now will bring forward what I believe would be the eventual outcome of political business as usual in Washington, which will continue without a default.

The United States is currently governed, for the most part, by a Democratic control of the executive branch, with its veto, and the Senate. Like it or not, the House can really only frustrate Democratic attempts to pass legislation, but it cannot, on its own, make policy.

Whether it's this group of Republicans, or another, after a brief return to Democratic control of the House, Senate, and Oval Office, and the final orgy of unaffordable deficit spending, it will likely now take some catastrophic event such as a credit rating downgrade and default to wake up Washington politicians to what is understood by many American voters and most global investors, to wit, no small change in American federal government fiscal policy will suffice any longer.

There must be wholesale changes in entitlement spending, the tax code and routine spending. Even leaving Social Security and Medicare untouched for the generation that concocted those Ponzi schemes won't suffice anymore, either. To truly fix what ails America, the coming fiscal pain must be shared by all, not only those victimized by the Porkiest Generation's self-interested entitlement scams.

Thus, I welcome a government shutdown, default and even a credit rating downgrade sooner, rather than later. Because it's coming, and later simply means more borrowed trillions for all of us to repay, with much higher interest. I don't believe most federal elected officials, nor Americans, truly comprehend the scope of the fiscal hole into which we've allowed our Congress and presidents to dig us since 1935. But it will probably require the economic equivalent of wartime belt-tightening for at least a decade to rectify it. By that I mean a near-total shift to defined contribution entitlements, retroactively changing Social Security, Medicare and Medicaid to such bases, large-scale elimination of federal spending on non-essential, non-common-good services, lower, globally-competitive tax rates, tax-preference item eliminations, and overal federal spending at or below 18% of GDP. Period. No more deficits.

To do otherwise, in my opinion, is like giving a self-confessed alcoholic more to drink, agreeing that he can always stop drinking tomorrow. Well, tomorrow will never come in that scenario.

And it won't in Obama's current fiscal scenario of off-limit programs for cutting, higher taxes, and modest, future spending cuts in exchange for the debt limit increase.

I know this seems to be a gloomy, dark scenario. But after decades of warnings of the insolvency of Social Security and Medicare, the continued unsustainable deficits spent by both parties, and a lack of awareness that there simply isn't time to avoid sharp spending cuts, I'd rather have external, uncontrollable fiscal consequences shut the door on liberal, big-spending American government starting in August, than rely on conventional, internal-to-America political swings to do it later.

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