Assistant Editor Bryce Covert sat down with Roosevelt Institute Senior Fellow Bo Cutter, who was director of the National Economic Council and Deputy Assistant to the President from 1992-1996 in the Clinton White House. In the first of a two-part interview, he explains why there is such limited time to raise the debt ceiling, how a default could lead to a double dip, and why every single American will feel the pain.
Bryce Covert: We hit the debt ceiling on Monday. What happens now to keep the government functioning?
Bo Cutter: What Tim Geithner can do is use various sources that throw off cash and use that cash to pay bills for a while. He can also stop access to debt from non-federal sources. Firstly, state governments get access to federal debt, which they often use as a safe holding place for money that has come in from one source and is going to go out on a project. They want zero risk associated with it, so they put it in short-term federal debt notes. They don't get a lot of interest these days, but it's absolutely safe, or it used to be. But if they buy that debt, it's new debt, even though it's short-term and it's going to be paid back. So Geithner has cut off access to that. That gives him slightly less demand for debt than he would have otherwise expected over the next few weeks.
Secondly, there is an aspect of the Federal Employees Retirement System, FERS, in which federal retirees and federal employees pay for some level of premium or copayment as part of their pension program. He can use that cash. Geithner has essentially taken it -- there's nothing that says he can't -- from the federal employees. It's going to have to go back, it's not a net reduction of debt, but it gives him working cash.
Finally, he can do the same thing with sources of income in the entitlement system. There are Medicare premiums and certain kinds of Social Security taxes, and he can use those for a limited period of time. All of this is essentially squeezing every bit of cash that's on its way to becoming debt for a variety of reasons. He takes it and uses it to pay bills for a while before it becomes debt.
Bryce Covert: How long can this process last?
Bo Cutter: The estimates are that when Geithner began to do this, which wasn't very long ago, he had about 11 weeks of give. That's why you see the estimation for default in approximately early August. No one quite knows the point at which it would become a real default, but it is something like the moment that someone who should have received interest doesn't and knows it. If I had a savings bond I might not check it every hour on the hour, so I might not actually know other than reading the newspaper that I didn't get my interest on a particular day. But my broker might tell me I'm not getting paid interest on my federal bonds anymore, and I might then check the next day, and at that point the US is in default.
The time available for freedom of movement is much less now than we used to have because the deficit is so much bigger. We're running about a $1.6 trillion deficit. So divide that by 12 and we are at approximately $130 billion a month, which is $4 billion, $4.5 billion a day. This says that Geithner had about 350 billion in spare cash lying around. Which isn't surprising. It's approximately 2% of GDP, and any big place is going to have a certain amount of slosh in it. But that's it. You don't have anymore after that.
Back in the Clinton days when I was in the White House, our deficit was approximately $220 billion and falling because it actually balanced for the last couple of years. So it was one sixth of the deficit today, which means we had six times the amount of time to play with if we really wanted to. Well, not quite six times, because population has grown somewhat so there's a little bit more cash, but the things that have increased the amount of wiggle room haven't increased as fast as the deficit has. Not even close. So in relative terms, Bill Clinton had a lot more time to play with than President Obama does.
Bryce Covert: What happens if we don't raise the debt ceiling in time?
Bo Cutter: You have to remember that all dollars are green. You can't tell one from the other. There is a tendency to think that we'll spend, but we won't spend the part of the money that increases the deficit. But if you're in deficit and you're building debt at the rate of $4.5 billion a day, there is no dollar that doesn't increase the deficit, including your interest payments. So the first thing that actually hits once you begin to run out of room is interest payments, because they're scheduled. The inability to pay interest is a default. If a whole set of Medicare bills are coming due, as they do every day, you can default. It hurts everything in the system. You can defer payment on Social Security for a week or something like that. The people who are receiving it get whacked, but you can do that if you had to. But you cannot defer the interest payments, and there are interest payments due every day.
Once you're in default, bad things begin to happen. It becomes irreversible. I suppose that if you were in technical default, which is to say you were in default and you missed an interest payment, but the problem got resolved and you were back within a day or so, it would still be quite damaging but I suspect that the world would recover. But it would create an absolutely rational crisis of confidence in the US government's capacity to pay. It would be in the market and there'd be no denying it.
If you're a government official, you have to take this really seriously. It is against the law to incur more debt and the sanctions can, under certain circumstances, be criminal, and they go to the person. Sometimes I hear, in particular in Congress but also on blogs I read, people acting a little bit as if this were a game. They think this fight is behind the scenes but people are kind of making payments anyway.
Bryce Covert: Some conservatives are using that term "technical default" and saying that it wouldn't be as bad for our economy as letting Congress spend over the $14.3 trillion limit. What is this distinction that they're trying to make?
Bo Cutter: There is no difference between default and technical default. A default happens if you can't pay interest. It's binary. You either pay it or you don't pay it. What they are trying to imply is that a little, teeny, short default surely wouldn't be a problem. They're right only in the sense that it would be less of a problem. If you were in frantic negotiations to come up with a deal and Tim ran out of money and there was nothing he could do, and he says we have four hours, we'd be in default on the payments that need to be made in those four hours. But you can probably avoid being in actual default because you could delay when you send out the electronic blips that say you've paid interest for half a day. That's technical default. That wouldn't be the catastrophe that Geithner has commented on. But it's a truly terrible thing and it's really stupid to get in that position. To argue that somehow or other we have until we get into technical default is crazy. I regard it as a distinction, not a difference.
I was watching Newt Gingrich on Meet the Press on May 15th and he used the same line that they all do, which is that they look very arch and say, you know there are games being played here and obviously you can stretch it out forever. But there are no games. Everybody knows these mechanisms. They've been written about extensively, they're not hidden. And they're really limited. There isn't some other magic pot of money. There used to be something called the exchange stabilization fund, and it was a fund that was off-budget and was in theory supposed to be used to stabilize the dollar. But when we did the Mexican bailout and we couldn't get any money out of Congress, in the end Secretary Rubin used the fund in order to do the bailout. Eventually we got back more money than he put in, but Congress got so mad that they took it away. They took away one of the big buffers.
Bryce Covert: What are the effects the country will feel in the event of a default?
Bo Cutter: As opposed to a shut down, there are two classes of effects, both bad. One is how it effects the economy as a whole, and then there are government payment effects. When a government shut down looked likely, I argued that in the short- and medium-run, the broad economic effects of a shut down are pretty close to zero. It's different with a debt ceiling problem were we ever to actually to go into default.
The right way to think about the economic effects is as follows. First interest payments increase, probably permanently. If you go into default for only one day maybe the permanent effect is only a little. But if you're in default in any substantial way, and I'd say that's more than a half a day, but let's say a week, then the interest rates on US debt go up forever. That's because the risk premium has suddenly appeared. The whole world thinks US debt is essentially risk-free. But that is suddenly going to change. So Americans will pay higher interest rates forever for debt. Since these days half of our debt goes to pay other countries who hold it, it's not money that one set of Americans is paying to another set of Americans, it's money that Americans as a whole are shipping out of the United States.
A lot follows from that. That means mortgage rates go up, it means loans to small businesses go up. One way to think about this is that if you increased by 20 basis points the interest paid on say a $170,000 house, you've increased over the lifetime of a 25- or 30-year mortgage the price that the consumer would pay by about $19,000. And a mortgage would certainly increase by 20 basis points. What's generally thought is that mortgages will increase about one and a half times more than federal debt because it's riskier. Then the increase in price would ripple from there to other kinds of debt. So everybody in America suddenly starts paying more for debt.
The next thing that happens is that growth slows. If people have to spend more of their money on interest, they're spending less of their money on things. Businesses are going to invest less. And the rate of growth is going to fall. Once again, this depends completely on how long a default lasts. But if it lasts a week or a couple of weeks, the rate of growth in the US economy probably falls around 1 percentage point. That's a big number. Consistent with that would be a rise in unemployment by about 600,000 people.
It's hard to see anything good coming out of those things. You could say it was a wash if it was money that one set of Americans owed to another set. That is a horrible way of thinking about a default, but if America's debt was all owed to America like it is in Japan, you wouldn't have some of these effects, because the money wouldn't be going out of the country.
Bryce Covert: Could one effect of default be a double dip recession?
Bo Cutter: Oh absolutely. Right now we're running at about a 2% growth rate. We've had a couple blips up, but if you average what everybody says we're doing, it's 2, 2.5%. So take a point out of that and it's not a danger, it's a certainty that we'll see a double dip. The issue is just how long the default is going to be. Back to the spurious technical default, if that's all it was it would just hurt everybody in America a little bit. If it were longer than that, we would experience the 1% fall in growth, and if it were a couple of weeks, which is inconceivable, there would be a double dip right away.
Bryce Covert: What are the effects of the government being unable to make other kinds of payments, beyond paying interest?
Bo Cutter: Everything else stops. You can't pay Social Security, you can't pay Medicare, you can't do anything. It's done. I'm sure that under even cataclysmic circumstances like this some rules of reason hold and people would be slow at layoffs and would try to slow walk it all, but they'd have to begin the process. Because if you're $1.6 trillion in deficit, you're spending $4.5 billion a day and that becomes illegal. So you have to start trimming in a hurry. You can't spend anything, period.
We've never actually been in default. So while we know what happens in a shut down and we know a little bit about what you can do to avoid it, we don't know what happens in this situation. But I've been asking my friends in the government for the last week or so, and they think that the kind of safe haven that is given to national security, including the defense department, homeland security, and FBI, would continue, but much more stringently. There would be a much, much tougher filter for who was regarded essential and who was not. As I told you, there had been a lot of thinking back when I was in government about how you operate in the case of a shut down. But since we've never had a default, people haven't been spending their time writing opinions about what you do at HUD in that situation. They'll have to quickly figure that out. Remember these are career public servants who are going to be criminally and personally accountable, so they're going to draw an increasingly tough line.
I think probably the way they would do it -- and it's insanity -- would be to chart a path down to zero deficit. A fast path.
Bryce Covert: What will the average citizen feel if the event of a default?
Bo Cutter: I think the absolutely first thing is a 1,000-point drop in the stock market in a day. That's the fastest reactor. I've been reading some estimates and the general consensus is that if there's a default that looks as though it will be real but short, the stock market probably falls 1,000-1,200 points, although there are much higher estimates in there but no lower. And if you think that that's probably a 50-75 basis point rise in the basic underlying federal rate, it probably means a 10% fall in the value of debt. Every piece of debt in America is on the market every day and is being priced. The stated nominal interest rate doesn't change, the value of the debt changes. So if you are a holder of debt in your portfolio, the value declines instantly. Everybody feels it right away. It's not just the recipients of federal aid as it would be in a shut down. Mr. or Mrs. Tea Party, who are all for this, will see their savings wiped out. Then they're mad.
Bryce Covert: What happens to the pensions that the Treasury borrows from? Does it affect the pensioners?
Bo Cutter: For a while no. It's a little bit like you run a business and you're in some difficultly on your personal credit card. So you take a little bit of the cash flow from the business (even though you shouldn't) and use it to pay your bill. You know that the next day you're going to be in better shape personally and then you can pay back the business and things are fine. If you do too much of it you've then harmed the business. But if you paid it back, there probably isn't any harm. In the Treasury's case it is taking funds that federal employees had a right to expect were being invested and you are on a cash basis not investing them. But remember contractually you owe them the return as if you had invested the cash anyway, so you're just going to have to make it up. It's not as if you can permanently take money away from federal employees or from the Medicare premiums or from Social Security.
But there's a point at which it clearly would. I see getting yourself into this position as a really, really bad thing. Not as if there's a little bit bad but it's okay and then there's a little bit more bad. It's really bad. Then there are degrees of bad. The longer it lasts the worse it becomes.