A Banana Republic with Economic WMD’s

Russia, Iran, and North Korea are now recognized as terrorist states with nuclear weapons of mass destruction. My argument in this post is that the legislated limit on the amount of debt the United States can issue has now made it a banana republic possessing weapons of economic mass destruction.

I’ll begin by unpacking both parts of that assertion. Politically, the US has in recent years taken on many of the characteristics of a banana republic including election denialism; an attempted insurrection; frequent death threats to, and occasional instances of, attempted violence against politicians; voter disenfranchisement; and unlimited election spending. The brilliant minds of the US financial sector invented subprime mortgages, mortgage-backed securities, collateralized debt obligations, and credit default swaps. These instruments were the primary causes of the global financial crisis of 2008-09. Now the debt limit has the potential to unleash economic mass destruction.

Serious Business

A government’s fiscal balance (surplus or deficit over both the short and long terms) and its appropriate debt-GDP ratio are serious and important policy issues. For example, the Government of Canada made major budget cuts in 1994-97 to restore fiscal balance after decades of large and growing deficits. After 25 years of strong finances, fiscal balance has re-emerged as a significant issue as the federal and provincial governments attempt to deal with the fiscal aftermath of the pandemic. Balanced budget amendments were championed decades ago by serious scholars like Aaron Wildavsky and have been enacted in many jurisdictions. They usually involve some flexibility in the definition of what is being balanced and the time frame over which balance is to be achieved.

Economic Terrorism

In contrast, the threat by right-wing fringe (Freedom Caucus) Republicans in the House of Representatives to refuse to authorize an increase in the debt limit unless major spending cuts are made is an act of economic terrorism. If there is no increase in the debt limit, the United States Government would be forced to balance its budget overnight. The deficit is now 5 percent of US GDP, so this would mean an immediate reduction of 5 percent of GDP, or approximately $1 trillion. Not only would that require large cuts in discretionary spending, but it would force the government to renege on many statutory commitments.

The domestic impact of reneging on statutory commitments is to sharply reduce consumer spending and capital investment as funds stop flowing from government to consumers and business. This bleeding of purchasing power, coupled with the increase in interest rates, would make a serious recession a certainty.

In addition, the US Government could be forced to default on its accumulated 31 trillion in public debt. Banana republics default on their debt because they no longer have the resources to service it. Costs are immediately borne by the holders of the debt but ultimately by the republic itself, as it is is either excluded from capital markets or faces higher borrowing costs. A default by the US would be different, because it can readily service its debt, but is choosing not to.

If the US starts to default on its debt, what will institutions that hold it (especially the $7 trillion held overseas) do? Will they sit tight and wait for the Washington windbags to come to their senses, or will they unload it? Debt holders attempting to sell so large a body of debt will drive up interest rates both in the US and globally, representing another recessionary force. In the long run a default will signal the unreliability of US Government debt and hence create a debt premium for the US relative to, for example, EU and Japanese debt.

How it Ends

In my view, nothing good can come of this economic terrorism. US legislators should have a serious discussion about restoring an appropriate fiscal balance and take action in that direction. But threatening economic terrorism – with all its costs for the US and global economies – is not the way to begin such a discussion.

In both houses of Congress, there are majorities consisting of all the Democrats and some Republicans that reject economic terrorism. But House Speaker Kevin McCarthy has sold his soul to the terrorists to realize the pinnacle of his ambition. He may be willing to bring the temple crashing down over his head as long as he can retain his power in the ruins.

The price of credit default swaps on 5 year US Treasuries has been steadily increasing recently, but still only implies a .5 percent probability of default. As the Treasury takes measures to delay a default until June, and the President and the Democratic leadership ponder whether and how to negotiate with the economic terrorists, perhaps this is the time to buy the default swaps.

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