Politically Driven Fiscal Crises Create Self-Inflicted Economic Wounds

The current political game of chicken that threatens to shut down the government or, even more seriously, could lead to an unprecedented U.S. default on its debt in mid-October is harmful for everyday Americans and businesses. Even getting close to a default can rattle markets, leading to increased borrowing costs for the U.S. and thus higher interest payments, crowding out resources for needs such as infrastructure, education, and scientific research. Economic disruptions caused by political battles in Washington only put more roadblocks in the way of an economic recovery.

The potential economic effects of a shutdown are examined below, followed by those that could come about due to a default.

A Government Shutdown, Especially if it is Prolonged, Will Hurt the Economy

The Senate Budget Committee held a hearing Tuesday on the impacts of budget crises have on economic growth and job creation.

A potential shutdown early next week—or at some later point—especially if it is prolonged could “affect hundreds of thousands of workers’ jobs and disrupt basic services from Social Security payments to small business loans,” said Senator Patty Murray (D-WA), chair of the Senate panel. Among other impacts, uniformed military personnel could stop receiving paychecks, the National Institutes of Health could stop accepting patients, and the National Parks would likely be shut down.

The longer the shutdown lasts, the more painful a shutdown will be. Mark Zandi, co- founder of Moody’s Analytics, testified that a shutdown "longer than two months would likely precipitate another recession," resetting the clock on the nation’s painfully slow economic recovery.

Twin partial shutdowns—a five-day shutdown between November 13-19, 1995 and a 21-day shutdown between December 5, 1995 and January 6, 1996—offer lessons. Those partial shutdowns cost the federal government more than $1.4 billion, which would be over $2 billion in today’s dollars due to inflation. This is probably a low estimate, because it does not fully factor in forgone revenues, opportunity costs and inefficiencies, and the impacts to local communities. 

A shutdown next week would likely be more widespread than in those shutdowns, which furloughed 800,000 employees and halted a range of government services, because this time around no appropriations bills have been enacted, unlike during those shutdowns.

The following chart presented by Zandi during the Tuesday hearing demonstrates how the disturbance from the shutdowns in the 1990’s was reflected in real gross domestic product (GDP) growth.

A shutdown– if it occurs over a weekend or just a couple days during the week–will mostly be an inconvenience to many, but would still diminish government effectiveness. Should it last longer, however, impacts would deeply affect the broader economy, beyond government workers and contractors and their families.

Even the Threat of Default Is Bad for the Economy

A second even more severe, potentially self-inflicted economic threat looms on the horizon. By mid-October, the nation will be forced to either raise the debt ceiling or default. Raising this ceiling allows the “government to borrow money to manage its day-to-day operations, much in the same way businesses need credit to manage the timing gap between payments and receipt,” according to the Senate Budget Committee.

The Economist has called a failure to raise the debt ceiling a “weapon of mass financial destruction.”

Ronald Reagan understood the dire consequences of a default when he warned in 1987:

Congress consistently brings the government to the edge of default before facing its responsibility. This brinksmanship threatens the holders of government bonds and those who rely on Social Security and veterans benefits. Interest rates would skyrocket, instability would occur in financial markets, and the Federal deficit would soar.

The same would be true today, as well. The debt ceiling is projected to be reached on October 17. The Bipartisan Policy Center has laid out the timeline for payment due dates that would immediately come after. For instance, on October 23, the Treasury needs to pay $12 billion in Social Security benefit payments. Medicare payments to providers and private plans running at $18 billion, more Social Security payments totaling $25 billion, and pay for the military and veterans running at $12 billion are all due on November 1. And so on. Without a debt increase, services would continue to be further strangled. Funding would eventually be unavailable for federal courts, air traffic control, education programs, and defense contractors, as well as a myriad of other services.

A default, coupled with the suffocation of funding that would result, would likely trigger chaos in financial markets, especially in an era of high-speed trading on Wall Street. A credit crisis could very quickly follow.  Donald Marrion, the Urban Institute’s economic policy director, explained why before a hearing before the Joint Economic Committee last week:

Large swaths of America’s financial infrastructure have been built on the assumption that U.S. Treasuries pay on time. Treasury securities serve as collateral in the short-term lending markets that provide trillions of dollars of liquidity to the financial system. In addition, money market funds hold Treasury securities to make sure they can repay savers’ investments.

Those financing arrangements all presume that Treasuries are money-good. If the federal government defaulted, those markets would begin to unravel. Credit would tighten, financial institutions would scramble for cash, and savers might desert money market funds. The magnitude of the resulting economic harm is difficult to judge and would depend on the scope and duration of the default.

Americans remember all too well the impacts of a credit crunch than began unfolding in 2008. The Financial Crisis Inquiry Report described the state of financial markets in 2008:

Panic and uncertainty in the financial system plunged the nation into the longest and deepest recession in generations. The credit squeeze in financial markets cascaded throughout the economy.

Approximately $17 trillion in household wealth evaporated in 21 months, millions of jobs were lost, and the economy is still barely staggering to its feet today.

Even if a default is avoided, Chad Stone, of the Center for Budget and Policy Priorities (CBPP), cautioned that brinksmanship around the debt ceiling would have economic costs. A close call in 2011 led to a 2,000 point drop in the Dow Jones index and nearly $19 billion in extra interest costs over ten years, according to the Bipartisan Policy Center.  

While a default was ultimately averted then, it ushered in the Budget Control Act and the indiscriminate sequestration cuts that hit this year. As a result of sequestration, the U.S. will forfeit as many as 1.6 million jobs in FY 2014. Although the manufactured fiscal crisis did not lead to a body slam to the economy, it led to a slow bleed out. Thanks to budget crisis politics, Americans were hit with fiscal policies that slowed growth and hurt job creation.

Another close call came in 1979. Congress got close to not raising the debt ceiling in time. But because it got so close to the wire, the Treasury Department, due to some technical snafus, defaulted on some debt. It was repaid with interest – but short-term interest rates shot up and cost the economy as a result, according to The Atlantic.

Playing Political Games

Federal Reserve Chairman, Ben Bernanke, acknowledged this month that current federal fiscal policy has been “an important restraint on growth.”

During Tuesday’s hearing, Zandi echoed Bernanke’s concerns, testifying that “Washington’s heated budget battles are a significant contributor” to depressed investment, low employment rates, and lackluster levels of entrepreneurship. He warned, “If [lawmakers] botch it and the government shuts down or fails to meet all its obligations, investor and consumer psychology will be undermined, and the economy will suffer serious harm.”

Chad Stone, Ph.D., of the Center on Budget and Policy Priorities (CBPP), referred to prolonged heightened uncertainty as an outright “anti-stimulus,” counteracting economic recovery.  

Even with a last minute deal, evidence suggests uncertainty cuts demand for goods and services, increasing unemployment rates and preventing job creation.

This uncertainly and its negative effects come on top of fiscal policies over the last few years that are smothering economic growth and job creation.

The economy needs to create over 8 million jobs to take us back to the employment levels that existed before the 2007 financial crisis began. Yet fiscal crises and anti-growth policies have made the job of rebuilding the economy much harder.

It’s time to reset the debates in D.C.:  pro-job growth fiscal policies that grow the middle class in a sustainable way need to be at the forefront of America’s political debates, not more austerity, tax cuts for corporations that are seeing record-high profits, and attempts to strip away safeguards for society and the environment.

Nick Schwellenbach, a senior fiscal policy analyst at the Center for Effective Government, contributed to this post.

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