With Friends Like These, The U.S. Economy Doesn't Need Enemies
If you want to understand the potential damage of a debt-ceiling showdown, you can start by looking at how much damage it caused last time.
The University of Michigan released its monthly report on consumer sentiment this morning, and in an odd coincidence, it reported that consumers are almost exactly as confident as they were in the late summer of 2011 -- right before their confidence collapsed and took the rest of the year to recover.
The event that caused the crisis of confidence? The debt ceiling. President Barack Obama and congressional Republicans clashed that summer over legislation to raise the legal limit on federal debt. Had they failed to make a deal at the last minute, as the story is usually told, it would have sent the economy and financial markets into a tailspin. And judging from news reports, we're headed toward just that sort of high-stakes political fight.
That's awful news for the economy. The lesson of the 2011 crisis is that while actually going over the debt ceiling would be a disaster, even a near miss would be a severe setback for economic growth.
While the 15-percent decline in stock market indexes was obvious at the time, the Michigan survey data show the damage was pretty persistent. It took eight months for confidence to rise back to its pre-crisis level.
Another way to assess the impact of the debt-ceiling crisis is to look at interest rates. What happened wasn't what you'd expect: It caused the rate on the 10-year Treasury note to drop a full percentage point in just over one month. The crisis in U.S. government debt caused investors to rush to safety -- into U.S. government debt. Debt ceiling or not, it was still the safe asset.
It's usually thought that the Fed's bond purchases drive down interest rates, but that's not the case. The first two rounds of quantitative easing actually pushed rates up, with monetary stimulus boosting growth, growth boosting interest rates. The fact that rates dropped all the way back down, and then stayed low, suggests that Congress's tantrum had an impact as large as QE2, but in the opposite direction. The mess fiscal policy makes in a month takes monetary policy years to undo.
But the effect that may have mattered the most, however, also took the longest to realize. The debt ceiling set off a chain of lowered expectations for economic growth. Economic forecasters spent the next two years writing away the prospect of a vigorous recovery. Before the debt ceiling, for instance, the Federal Open Market Committee, which sets monetary policy, had thought the U.S. would see gross domestic product growing at 4 percent, adjusted for inflation, in 2011, 2012 and 2013. By the end of 2011, they had concluded that growth would run at half that pace.
The FOMC now pegs its forecasts for U.S. GDP growth in 2014 and 2015 at just above 3 percent. But it said in the last meeting it's once again worried about "fiscal retrenchment" and kept the monetary spigot flowing. That's code for the debt ceiling. If the next few weeks bring us any closer, the Fed's forecasts will once again be over-optimistic.
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