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Rebels without a clue

Oct 01 2013, 22:25 IST
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SummaryThe Republicans are flirting with financial disaster pushing the government towards a shutdown

Paul Krugman

This may be the way the world ends—not with a bang but with a temper tantrum.

OK, a temporary government shutdown—which became almost inevitable after Sunday’s House vote to provide government funding only on unacceptable—wouldn’t be the end of the world. But a US government default, which will happen unless Congress raises the debt ceiling soon, might cause financial catastrophe. Unfortunately, many Republicans either don’t understand this or don’t care.

Let’s talk first about the economics. After the government shutdowns of 1995 and 1996 many observers concluded that such events, while clearly bad, aren’t catastrophes: essential services continue, and the result is a major nuisance but no lasting harm. That’s still partly true, but it’s important to note that the Clinton-era shutdowns took place against the background of a booming economy. Today we have a weak economy, with falling government spending one main cause of that weakness. A shutdown would amount to a further economic hit, which could become a big deal if the shutdown went on for a long time.

Still, a government shutdown looks benign compared with the possibility that Congress might refuse to raise the debt ceiling.

First of all, hitting the ceiling would force a huge, immediate spending cut, almost surely pushing America back into recession. Beyond that, failure to raise the ceiling would mean missed payments on existing US government debt. And that might have terrifying consequences.

Why? Financial markets have long treated US bonds as the ultimate safe asset; the assumption that America will always honour its debts is the bedrock on which the world financial system rests. In particular, Treasury bills—short-term US bonds—are what investors demand when they want absolutely solid collateral against loans. Treasury bills are so essential for this role that in times of severe stress they sometimes pay slightly negative interest rates—that is, they’re treated as being better than cash.

Now suppose it became clear that US bonds weren’t safe, that America couldn’t be counted on to honour its debts after all. Suddenly, the whole system would be disrupted. Maybe, if we were lucky, financial institutions would quickly cobble together alternative arrangements. But it looks quite possible that default would create a huge financial crisis, dwarfing the crisis set off by the failure of Lehman Brothers five years ago.

No sane political system would run this kind of risk. But we don’t have a sane political system; we have a system in which a substantial number

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