Washington Follows Path to Credibility Downgrade: Neil Barofsky

July 27 (Bloomberg) -- We have been told that unless the legislative process is well under way by today, and a bill raising the debt limit is passed and in place by Aug. 2, catastrophe will strike the U.S.

This follows previous warnings of other calamitous deadlines that have come and gone with little tumult, such as Treasury Secretary Timothy Geithner’s January claim that the debt limit had to be raised no later than March 31. That deadline passed, followed by a series of other supposed moments of truth in June and July, and most recently, the proclamation by congressional leaders that a deal had to be announced by 4 p.m. this past Sunday before the Asian financial markets opened.

Fortunately, these predictions, so far, have been off the mark. While there may have been market shudders, the predicted Great Panic of 2011 hasn’t struck.

Treasury’s warnings raise two important questions. Why has it served up visions of the apocalypse time and again and what have been the costs of it being wrong?

The most obvious cost has been an incremental loss of credibility, with even the oft-cited Aug. 2 deadline for Congressional action now widely questioned. Reluctant Congressional Republicans, Geithner’s intended audience, long ago lost their faith in Treasury and view the deadline warnings as mere political spin.

False Twilights

After all, this isn’t the first time in recent years that there have been warnings of dire consequences that haven’t come to pass. For example, the Federal Reserve’s repeated predictions that severe damage would result if it were forced to disclose the identities of its counterparties during the financial crisis were wrong, as were Treasury’s warnings that my former office, the Special Inspector General for the Troubled Asset Relief Program (TARP), would inflict financial carnage when it announced its survey of what lending institutions had done with the taxpayer funds they had received under the program.

So why keep issuing what appear to be false deadlines?

The obvious answer is it’s part of an attempt to gain political leverage. Congress apparently can no longer act without deadlines, and by planting them early and often, the hope must have been to gain some traction in negotiations and achieve the concessions necessary to garner bipartisan support for a deal. These pressures may have been part of the reason Republican Speaker of the House John Boehner came close to reaching an agreement with the Obama administration before the deal fell apart last week with the now all-too-familiar accusations of bad faith by both sides -- and leaving us with even less time to find a solution.

Political Goals

The false alarms also were intended to serve other political goals. One of the sharpest criticisms aimed at Geithner, his predecessor Hank Paulson and other federal regulators in the aftermath of the 2008 financial crisis was their failure to recognize the danger created by financial institutions’ reliance on supposedly safe subprime mortgage-backed securities -- bonds that once held the same AAA rating as Treasury securities. By sounding alarms, the administration wanted to limit its vulnerability and be in a better position to build on the narrative set forth by President Barack Obama in his Monday night address: blame for default lies not with the White House, but with Republicans in Congress who ignored these admonitions.

Treasury’s warnings will also have the benefit of eventually proving to be accurate if the true deadline passes without a deal (whatever date that may actually be) and the U.S. fails to make its debt payments. While wrong on dates, Geithner, of course, would ultimately be correct that should the U.S. default on its debt, the impact on the markets would likely far exceed even the darkest days of 2008.

Takes a Collapse

Finally, the early predictions of chaos could, in a perverse way, reflect recognition that it may take a collapse in the markets to galvanize congressional action. During the last crisis, it was only after the panic that followed the first unsuccessful Congressional vote on TARP -- which caused the single largest one-day drop in the Dow Jones Industrial Average -- that Congress recognized the need to take action. Perhaps the path toward a meaningful compromise will again only be made clear after both sides are confronted with a sample of the consequences of this dangerous political game that they are playing with our country’s economy.

Although the recent financial crisis proved that it is extremely difficult for the government to stem a panic, it also demonstrated -- as reflected by the markets’ freefall during Geithner’s announcement of his financial stability plan in early 2009 -- that a few ill-chosen words from the Treasury secretary can inspire one.

(Neil Barofsky, a senior fellow and adjunct professor at NYU School of Law, was Special Inspector General of TARP and is a contributing editor for Bloomberg TV. The opinions expressed are his own.)

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