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3Qs: As debt-limit deadline nears, more economic pain looms

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Treasury Secretary Timothy Geithner says Congress has until August 2nd to approve an increase in the federal debt limit — enabling the Treasury to borrow more money — or the U.S. government will not be able to meet all of its financial obligations. Congressional Republicans are demanding deep cuts to reduce the federal budget deficit in return for approving a debt-ceiling increase; Democrats prefer a combination of budget cuts and increased revenues in the form of targeted tax hikes. Negotiations broke down last week, and President Obama has now stepped in to try to salvage a deal. Here, Northeastern finance and economics instructor Richard Goettle discusses what could happen to the financial markets and economy as a whole if Congress and the White House fail to find common ground.

The markets often anticipate bad news and factor it into prices ahead of events. How do you see that playing out in this case? How badly could the markets be hurt by the impending threat of default?

To a certain extent we are in uncharted waters here. We had two government shutdowns in late 1995 and early 1996 arising for much the same reasons — a Democratic president at loggerheads with a Republican Congress. Financial markets became more volatile but did not experience dramatic declines. Back then, however, the most recent recession was in the distant past and the economy was in the earliest stages of the dot.com expansion. Today there is more pessimism and doomsday rhetoric because we are in the midst of an on-going global debt crisis and the world’s economies appear extremely fragile.

The degree to which markets take a big hit will depend on how temporary or permanent the shutdown appears to be, if indeed it occurs. If markets believe it will be short-lived, then it will not result in a precipitous shock. If, on the other hand, the perception is one of a prolonged shutdown increasing the likelihood of a true default, then markets certainly will reflect this.

If August 2 arrives without Congress approving an increase in the debt ceiling, what are the options for the Treasury Department, in terms of what bills and debts get paid?

Failure to approve the increase in the debt ceiling will not cause an immediate default on U.S. debt obligations. On a monthly basis, the United States spends around $325 billion and takes in about $208 billion. Monthly interest on the national debt is about $25 billion. So we could cover principal and interest on U.S. debt obligations with current tax receipts and not default. This would force spending reductions or tax increases totaling roughly $120 billion a month to compensate for any spending gap.

In the 1995 and 1996 shutdowns, the Treasury and the Office of Management and Budget developed spending priorities for essential services — debt servicing, national defense and security, benefit payments and the protection of health, life and property.

To the extent it would occur today, there is no question that a shutdown would have serious ripple effects throughout the economy. Currently, public discussion centers on vague, worst-case scenarios; the devil would be in the details of what the Treasury actually funds in the event of a shutdown. It will have to fund debt obligations to avoid default and also services deemed essential, however those are defined. But numerous government services would be curtailed, delayed or eliminated for the duration.

If we should go into default, some are predicting an economic upheaval much worse than what just occurred in 2008, closer in impact to the Great Depression. Could you talk about the most likely short- and long-term impacts?

Assuming that the debt ceiling is not raised, the likelihood of default increases to the extent that ongoing tax revenues cannot support our debt obligations and the limited essential services still being provided. But I cannot imagine a prolonged shutdown once politicians actually see what eliminating $120 billion per month actually means in terms of services. Brinksmanship will have a huge political penalty for those who choose to prolong the economic discomfort.

But for the longer term, the U.S. debt crisis is very real. The U.S. and many of the world’s economies are on unsustainable paths. The world needs to deleverage, which requires sacrifices by all and a willingness to incur them. If the debt ceiling and debt crisis issues are not addressed in responsible ways, this will only increase the destabilizing influences now at play in world financial markets, both for the near and longer term.

Debt crises take a very long time to unwind, but neither the Great Recession nor the Great Depression need be repeated if more thoughtful and reasoned heads were to prevail. If not, then it’s anybody’s guess.