I had been assuming that somehow we'd figure out a way to muddle through the debt ceiling without imposing much harm on the economy, in part because the markets haven't yet assigned any weight to the risk of default. But I'm starting to think about the problem differently. Here is how Alan Blinder puts it:
[M]arkets now assign essentially zero probability to the U.S. losing its fiscal mind. They'd be caught flat-footed if the threat of default suddenly started to look real, possibly triggering a world-wide financial panic. Remember how markets reacted to the Lehman Brothers surprise? As Mr. Geithner pointed out in New York on Tuesday, "As we saw in the fall of 2008, when confidence turns, it can turn with brutal force and with a momentum that is very difficult and costly to arrest."
Markets might be missing a default crisis for the same reason they missed the credit crisis. There's massive systemic risk embedded in the system, but the markets have remained complacent simply because the consequences haven't revealed themselves. In this case, the risk is some unusual features of our political status quo. In this case, it's a political system in which the opposition party has a veto over any policy change and a political incentive structure diametrically opposed to the interests of the economy. Add on top of that a unique requirement for a specific vote to raise the debt ceiling. And throw on top of that the fact that this particular opposition party is run by an ideological movement frequently in the habit of dismissing the conclusions of experts, and is thus unamenable to stern warnings from economists and bipartisan financial elites. It's a very dangerous combination.
If you think Republican leaders sound cavalier about the risks of debt ceiling chicken, read this Reuters story by Nick Carey. I don't want to just pull out a paragraph of it. It's a detailed piece of reporting showing that, within the world of Tea Party activists, the situation looks radically different than it appears to the U.S. Chamber of Commerce. There, the debt ceiling does not need to be lifted at all, ever, and the fact that Republicans are even contemplating doing so proves their cowardice. Indeed, John Boehner and Eric Cantor understand full well that they may face right-wing primary challenges if they support a debt ceiling hike. As Stan Collender notes, they have to take this to the limit. To outsiders, gaming the debt ceiling until the last minute and only acting after the market panics seems unimaginably irresponsible. To Boehner and Cantor, it's pushing conciliation as far as it can go, to the point of risking their careers.
That leaves the possibility of a bipartisan deal to reduce the long-term deficit tied to a debt ceiling increase. The problem here is that this would force the Republican leadership to sell the base on one unpleasant thing (the debt ceiling) by pairing it with another unpleasant thing (a budget compromise.) Derek Thompson talks to Senate republican staffers and unspools the grim logic:
1) The only bipartisan deal to raise revenue will be to close loopholes rather than raise rates. This is how the bipartisan deficit commission attracted the support of Republican Sens. Coburn and Crapo. But...
2) The only senators talking about closing loopholes want to do so through comprehensive tax reform. And...
3) Nobody in Washington thinks we can get comprehensive tax reform before August, when the debt ceiling vote is due. Moreover, given the lack of progress from the Biden talks and the Gang of Six, not a single spokesperson I talked to expected budget reform before the end of 2011.Therefore...
4) There will be no comprehensive budget reform, which means there will be no tax loopholes closed, which means there will be no plan to raise revenue.
More than anything, Democrats need time to get Republican senators behind base broadening; Democrats behind spending sacrifices; and the economy healthy enough to accommodate tax increases. That's time that the debt ceiling doesn't have.
Meanwhile, Tom Coburn, until recently the shining hope of a grand debt bargain, is now planning to demand $9 trillion in cuts over a decade, more than twice what Bowles-Simpson proposed. I don't see any bipartisan debt bargain saving us here.
What could save us? One possibility is a massive unilateral policy concession by the Obama administration. I think that's a terrible idea because, among other things, it would simply encourage Republicans to repeat the exercise again.
I think it just has to go down to the wire, and reach the point where the business lobby panics enough to exert enough pressure on Republicans to balance out the pressure from the base. And that point probably won't occur until the market has actually reacted to the impasse. Hopefully it won't be too late.