Again: the issue is the economy, not default

Two important events with importance to financial markets have occurred in the last 24 hours. Last night John Boehner pulled his debt ceiling bill for lack of Republican votes. This event adds to the chaos surrounding the debt ceiling and increases the chance that no agreement will be reached by Tuesday, when Treasury borrowing hits the legal ceiling. This morning the Bureau of Economic Analysis reported that GDP grew only 1.3 percent in the second quarter, following a miserable 0.4 percent gain in the first quarter (in normal times with full employment we want something like 3 percent growth; to get out of our current recession in a reasonable amount of time we need something like 5 percent for awhile).

So what did the financial markets do? So far, stock prices are falling while Treasury bond prices are rising. Wait, rising? That means yields are falling. Let me check that - yep, interest rates on ten-year Treasury bonds fell from 2.95 to 2.88 percent this morning. I thought that the prospect of default was supposed to drive bond yields up because no one wants to lend to a government that doesn't seem to want to pay its bills. That's odd.

Well, it really isn't odd. Everyone knows that the Treasury is going to continue to make payments on its debt. Even if the debt ceiling is reached on Tuesday with no agreement, the Treasury will have enough money coming in from tax revenues to make those payments. At risk is the rest of the budget: Social Security payments, payments to government contractors, federal government employee salaries, electric bills for government agencies, and so on. If that spending is curtailed it will be incredibly damaging to the American economy. The total amount of spending cuts amount to something like 10 percent of GDP. Given that GDP growth is already perilously close to zero, it almost certainly would push us back into another recession. That's why the stock market is dropping. And if the economy weakens further the Federal Reserve is likely to begin another round of quantitative easing to push interest rates down - that's why bond rates are falling now.

It's quite likely that the chaos over the debt ceiling was a contributor to the slowdown in the second quarter and this month. News reports claim that businesses are putting off purchases and hiring to hoard cash in case of a disruption of payments or an economic slowdown. Go back a few posts to see what this does to the economy: more demand for money means less demand for goods and labor. The solution is for the Fed to add reserves to the banking system to satisfy people's desire for money. If it does this by buying long-term bonds of various kinds it reduces interest rates enough to encourage people to stop hoarding and start spending. But QEII ended in June - the Fed is keeping reserves constant for now.

So this looks to be another strategic blunder on the part of the Obama Administration. Months ago the administration should have made it clear that it would not default on the debt, that it would not let Congress' failure to pass a debt ceiling bill prevent it from paying its bills. It could have been coy about how it was going to do this - invoke the 14th Amendment? the platinum option? surely there are enough creative minds in the White House Counsel's office to come up with a way around the debt limit. I guess the reason the Administration did not do this was that it thought that by generating a sense of crisis it could force Republicans to sign onto a budget deal that would resolve some long-term fiscal issues. Turns out that is not the case, and now we're left with the crisis without the deal. Well played!