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Douglas Holtz-Eakin Headshot

No Reason Debt Limit Debate Has to End in Disaster

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To date, watching the government close for the first time in 17 years and witnessing the debate over raising the debt ceiling has been as much fun as reruns of the Hindenburg landing. But there is no reason why this has to end in disaster.

Step one is to recognize the very real risk of financial conflagration if the debt ceiling is breached. The only argument to the contrary is that the Treasury could somehow "prioritize" to pay interest, thus avoiding a formal default, and that financial markets would be assuaged by this bureaucratic legerdemain.

Wrong, on both counts. The computer software and systems needed to engineer this scheme could not possibly be operational by the end of October; and even if it was, financial markets would still recoil in horror. The basic question that lenders ask is whether the borrower is financially capable of meeting the obligation to repay, with interest. The spectacle of a country unable to pay Social Security, Medicare, energy contractors, highway construction, food stamps, or other obligations -- even though their interest costs are kept current -- would undermine that confidence. The result would be loans only at the higher interest rates charged to the riskiest borrowers. The economic headwind of higher interest rates would exacerbate the already-disappointing pace of economic recovery.

If confidence in the U.S. dipped enough, Treasury securities could actually trade below par, at less than a dollar-per-dollar of face value. At that point there will be a rush for the exits, market chaos, and the dollar will cease to anchor global financial markets. Not exactly a good objective for public policy.

Step two is to recognize that time is short. Negotiating takes time. Drafting, debating, and passing legislation takes time. The consequences of running over the debt limit are so severe that it is mystifying that the president and Harry Reid are content to do nothing as the U.S. approaches it. Prudence would argue in favor of getting a deal in as timely a fashion as possible.

Step three is to recognize that a negotiated deal is both necessary and waiting to be struck. The government is both divided politically and populated by elected officials representing widely divergent policy views. These legitimate differences can only be bridged by principled compromise borne of negotiations. A naïve belief by the House, Senate, or White House that they can "not negotiate" or "hold out" for its position is simply dangerous.

It would also be at odds with history. Largely because divided government is more the norm than the exception, debt-ceiling increases typically are accompanied by legislation intended to control the rising debt. Which, it should be noted, remains the real problem even after the limit is increased.

A "grand bargain" is simply a bridge to far. But a small scale reform to so-called "mandatory" spending -- entitlements like Medicare, farm programs, unemployment insurance, and so forth- - could easily generate enough savings over the next 10 years to relax the pressure that has been placed on defense and non-defense spending by the sequester, lower overall future spending and debt, and provide headroom for a sizable debt limit increase. It would also have the added benefit of sending a signal to the rest of the world that the U.S. is finally starting to get responsible.

Democrats would get what they want -- a more robust near-term domestic agenda. Republicans would get what they want -- strong defense and shift in focus to the fastest-growing part of the budget. And the president would eliminate debt limit drama during 2014.

The turmoil in Washington is troubling. But there is a clear path to a soft landing if all sides respect the historical precedent, negotiations begin quickly, and the focus is on the spending side of the budget.