07/17/2011 10:54 pm ET | Updated Sep 16, 2011

MAD About the Debt Ceiling

As the debt ceiling debate swirls around Washington, few observers think it will come to an actual default. In the political calculus, no one is willing to believe that the Parties will engage in a form of Mutually Assured Destruction ("MAD") of the "full faith and credit of the United States." But as the days tick down towards August 2, more people ask themselves if default might really be possible.

Economists from Larry Summers to Paul Krugman to new IMF chief Christine Lagarde warn of "dire consequences." But nobody can spell out a specific, step-by-step scenario. Because, like anything to do with markets, the exact details depend on the inherent complexity of human behavior. It can be predicted in general terms, but never in detail.

There are three basic reasons why a panic developing out of a U.S. default would be "post Lehmann on steroids" as Larry Summers put it in an interview with Charlie Rose.

  1. No bail out. No TARP-2. If Congress is so deadlocked that it can't do something relatively simple, like raise the debt ceiling, there is clearly no political will for any form of bail out. Everyone would be on their own.
  2. No safe haven. During the 2008 debacle, investors fled into U.S. Treasury debt obligations. Even though they paid close to zero interest. No gain, but no pain. Guaranteed. By Uncle Sam, specifically by the "full faith and credit of the United States government." But that is exactly what would be broken this time around. There is simply not enough gold in the world, or even paper currency to stuff under mattresses, to absorb the crush of investors trying to avoid total annihilation of their asset values. In other words, no bottom to how far down markets could go before stopping.
  3. Too big to fail? The U.S. government could prop up the biggest banks in the world. But who can prop up the U.S. government? Not even China could, even if they wanted to.

In the 1950's, one of my Ph.D. thesis advisors worked on simulations of what would happen to a city after a hydrogen bomb attack. How would the city recover? After lots of complicated modeling using the most sophisticated math and computer algorithms available at the time, the study came to a stark, simple answer. The city would not recover. Ever.

The only way to survive a thermonuclear war is not to have it. Hence, the notion of Mutually Assured Destruction: the rational, cynical, and expensive response to the irrational prospect of an event from which there is no recovery.

With the waning of the Cold War, one could hope that Mutually Assured Destruction would be consigned to history books. The acne of humanity's adolescence. Too bad to see it re-emerge in the headlines of our domestic politics.