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The Federal Government Races to the Cliff

In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken. Both intend to jump out at the last moment. But the other guy miscalculates, and goes over the cliff with the car.

This is the game that is being played out in Washington this month over the debt ceiling. The chance is at least 1/4 that the result will be similarly disastrous.

It is amazing that the financial markets continue to view the standoff with equanimity. Interest rates on US treasury bonds remain very low, 3% at the ten-year maturity. Evidently it is still considered a sign of sophistication to say “This is just politics as usual. They will come to an agreement in the end.” Probably they will. But maybe not. (I’d put a ½ probability on an agreement that raises the debt limit, but just muddles through in terms of the genuine long term fiscal problem. That leaves at most a ¼ probability of a genuine long-term solution of the sort that President Obama apparently proposed last week - described as worth $4 trillion over ten years.)

My advice to investors is to shift immediately out of US treasuries and into high-rated corporate bonds. If the worst happens, you will probably save yourself from a big capital loss within the next month. If not, there is no harm done.

The game is not symmetric. The Republicans are the ones who are miscalculating. Evidently they are confident of prevailing: they rejected the President’s offer, even though he was willing to cut entitlement programs.

The situation is complicated because there are a number of different people crammed into the Republican car. There is one guy who is obsessed with the theory that, come August 3, the federal government could retain its top credit rating if it continued to service its debt by ceasing payment on its other bills. But this would mean failing to honor legal obligations that have already been incurred (paying suppliers for paper clips that have already been bought, paying soldiers their wages for last month’s service, sending social security recipients their checks, etc.). This is like observing that the cliff is not a 90 degree drop-off, but only 110 degrees. It doesn’t matter: the car would still go crashing into the ocean far below. The government’s credit would still be downgraded and global investors would still demand higher interest rates to hold US treasuries, probably on a long-term basis.

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There are other guys (and gals) in the car who are even more delusional. They are dead set on a policy of immediately eliminating the budget deficit (e.g., those opposed to raising the debt ceiling no matter what, or those campaigning for a balanced budget amendment), and doing it primarily by cutting nondefense discretionary spending. This is literally impossible, arithmetically. But they honestly don’t know this. It is as if they were insisting that the car can fly. Sometimes it can be a good bargaining position to adopt a very extreme position. But if you are demanding that the car flies, you are not going to get your way no matter how determined you are.

It seems likely that the man in the driver’s seat - House Speaker John Boehner - does realize that his fellow passengers don’t have the facts quite right. But there is also a game of chicken going on within the Republican car. The crazies have said they will oppose in the next Republican primary election any congressman who votes to raise the debt ceiling or to raise tax revenues. (Yes, they think they would support someone who would eliminate the budget deficit primarily by cutting non-defense discretionary spending; but remember, this is arithmetically impossible.) The guy who is riding shot-gun in the car - the one who believes the car can fly — is trying to put his foot on top of Boehner’s on the accelerator pedal.

It seems to me that Boehner, too, is miscalculating. Given that the car can’t fly, the crazy guy is probably going to oppose him in the primaries no matter what he does. So I don’t see what his plan is. But whatever it is, he has made it clear that he doesn’t plan to agree to any increase in tax revenues.

As a result the Republican leadership is in the remarkable situation of refusing to agree to Obama’s offer to solve the problem so long as the solution includes raising tax revenue, even if it is via such measures as ending distortionary subsidies for ethanol, oil companies, and corporate jets.

If I had to guess: The financial markets will wake up just before August 3. US bond prices will finally fall. The market reaction will shock the Republican leadership into action. (Precedents include the delayed congressional passage of the unpopular TARP legislation in the fall of 2008 and the delayed passage of an unpopular IMF quota increase 10 years earlier.) They will finally make the small but necessary concessions on tax revenues. But by then it might be too late.