1937

(click here for animation)

I agree with Krugman again:

How bad will it be if we don’t manage to raise the debt ceiling? ...

First, US government debt plays a special role in the financial system: T-bills are the universal safe asset, the ultimate collateral. That’s why, during moments of financial stress, the interest rate on T-bills has actually gone negative. Make that safe asset suddenly unsafe, and it might cause vast disruption.

Krugman should make the point much stronger. It will cause vast disruption. And not just for the U.S. financial system, although that would be bad enough. The effect on the global financial system would be far worse. There's a reason why, following the biggest financial crisis since the Great Depression, capital actually flowed into the U.S. banking system, which was the epicenter of the storm. It's because the U.S. was at the epicenter of the storm. Stabilizing the U.S. was necessary to stabilize the global financial and economic system. If you click on the link above and watch the animation, you'll notice that the U.S. becomes more central to the global banking system over the period 1999-2010. And you'll even notice that, while the network wobbles after the shock in late-2008, it reinforces itself pretty quickly. Why? Because if the U.S. went under, then all those thick black lines would disappear, and everyone else would go under too.

What does this mean? It means that the rest of the world is heavily invested in the U.S. Which means that if the U.S. has a downturn, the global economic system has a downtown. If the U.S. refuses to raise the debt ceiling, there are two possible outcomes, which are not mutually exclusive: quick, harsh austerity that will crush what little recovery we've had; some form of default on debt. In truth, one implies the other. Both of them involve a massive collapse in global aggregate demand, as well as the mother of all bank runs. This is important because U.S. Treasury bills are considered "riskless" by financial institutions around the world. If the "riskless" assets become risky overnight, the effects on bank balance sheets will be catastrophic. Global regulatory structures will effectively cease to exist (since enforcing capital requirements would make every bank insolvent), and runs on financial institutions will occur almost immediately. The U.S. won't be able to intervene to stabilize the banking sector since its debt-spending capacity has been eliminated, so the banks all melt down. If that happens, not only would the U.S. economy crash the world economy would crash as well. There are few countries immune from an American virus. This would be a pandemic.

Moreover, it's just not necessary. The U.S. can currently borrow for five years at negative real interest rates (i.e. adjusted for future inflation). That means that other people will currently pay us to take their money. Let me repeat: Other people will pay us to take their money for the next five years. Instead, we're considering blowing up the global economy. Bad deal.



What happens when global economies blow up? Well, all of the examples we have are pretty bad. They tend to lead to long depressions, world wars, nuclear bombs being dropped, that sort of thing. I'm trying not to be too hyperbolic, but the major thing separating this crisis from the 1930s is a series of global institutions that are buttressed by economic stability in the U.S., integrated Europe, and Asia. If we blow that apart, then things can get ugly very quickly. Quite frankly, I'd rather not conduct a natural experiment to see how well various IR theories hold up.

For these reasons, I don't think it will happen. I don't want to put anything past the current Congress, which is as petty and short-sighted as every other Congress, but the stakes here are just too high. Then again, we've been in similar situations before, and they didn't always end well. If Congress is engaged in a game of chicken, then I hope they're ready to jump. This isn't worth toeing the line.