No Good Choices: Why a Short Term Debt Limit Extension Is on the Table

Politico last night highlighted a scenario that has become my ‘base case’: a short-term debt limit extension followed by a government shutdown at the end of March.  This consolidates the three cliffs–debt limit, sequester, and continuing resolution–into one larger showdown that, hopefully, produces an agreement some time in April.

This scenario has become a focus ahead of a Republican House retreat on Wednesday and reports that perhaps half the Republican caucus favors default if significant spending cuts are not agreed.  I’ve previously blogged on why using the debt limit is a terrible idea; scenarios where the debt limit bites and Treasury prioritizes would have a quick, devastating and politically nonviable effect on the economy. From this perspective, the short-term debt limit extension is seeks to shift the battle onto ground less damaging to the U.S. economy and the government’s long-term creditworthiness.  Call me an optimist.

The president in his press conference today pushed back, again rejecting negotiating over the debt limit.  He also seemed to signal support for a $1.5 trillion package (sufficient to bring overall deficit reduction in his first term to $4 trillion) in spending cuts and revenue.

While a broad deal that avoids the cliffs remains possible, for now each side will continue to float alternatives in order to show toughness ahead of a contentious negotiation. The main argument for the alternatives is that, as bad as they are, a comprehensive default by the U.S. government is worse.  It’s a ‘theory of the second worst’.

On Sunday, the U.S. Treasury shot down the idea of a $1 trillion dollar platinum coin.  Good for them. Of the ideas for evading the debt limit, this would have caused the highest collateral damage both for the Federal Reserve (which would have been signaling its willingness to accept the coin as currency and monetize the deficit directly) and for the credibility of fiscal policy over the longer term.

Most also believe that the Administration is not interested in using the 14^th Amendment to the Constitution, and its injunction that the validity of the debt shall not be questioned, to end-run the debt limit.  The more likely escape hatch is the creation of debt or other IOUs that are not subject to the debt limit.  One variant of this comes from Paul Krugman, who has called for the government to issue “Moral Obligation Coupons” that has no explicit legal obligation to repay. Once a deal is reached, this debt would be normalized.  This also has costs–debt not subject to the debt limit would be more costly than existing debt and the market would become fragmented, but as a short-term bridge to avoid default it is perhaps the best of the bad options if default is looming.

I assume that an April agreement would result in material, but back-loaded, spending cuts to discretionary spending and entitlements.  This means that the fiscal drag this year would be limited to the January 1^st fiscal cliff deal–about 1 ¼ percentage points.  The effect on growth in 2013 would be 1 percentage point.  If alternatively, the sequester goes into effect as part of the spending cuts, the fiscal drag rises to closer to 2 percentage points.

Against this background, a short-term debt limit extension, a temporary government shutdown when the current CR expires, and then a deal cutting spending gradually over time seems positively upbeat.