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In Praise of Imperfection

09/27/2013

Long ago and far away, I used to teach a junior level course at the University of Texas at Arlington called “Economics of Money and Banking.”   During that course, I would teach that the risk/reward principle (higher risk deserves higher reward) applies to the pricing of loans as well.  That explains why a successful doctor might get a car loan at 8%, while a person with two bankruptcies on their credit report might pay 18% for a loan on the same car.  That is largely still true.

In a perfect world, or at least the world before 2008, that would be true for governments as well.  When Congress was dysfunctional over the debt ceiling in 2011, I didn’t really think the Republicans would allow a default, because we cannot afford to pay more on our enormous national debt.  Remember, a 1% increase in our debt service on $15 TRILLION debt (2011) would be additional spending of $150 BILLION, which digs our hole even deeper.
There are no moralist overtones here.  Bad credit doesn’t pay a higher rate of interest as punishment.  They just need to pay more to entice somebody to loan them money or buy their bonds.  If we prove ourselves either un-creditworthy or un-governable, buyers of Treasury bonds will naturally shy away from us and not buy our Treasury bonds,
However, even though we lost our AAA credit rating, the interest rates we pay did not increase.  Why?
In our imperfect world after 2008, Ben Bernanke and the Fed came to the rescue by buying our bonds, which is called quantitative easing.  If some buyers of Treasury bonds shied away from us, the Fed would simply buy those bonds.  In other words, the demand of our bonds or debt did not decrease, and we didn’t have to pay more in interest cost to sell them.  Because of this, we have paid much less in debt service than we deserve..
Nobody knows how long this can continue, as the Fed’s balance sheet has grown geometrically.  But, the sooner we stop, the sooner we can stop begging the question.
For the past two weeks, the stock market has been factoring in a government shutdown and now expects a shutdown on Monday to happen.  The market will drop on Monday but not frighteningly so.  It will continue to drop each day until the end of the shutdown becomes clear.  However, the market has not factored in a default or failure to lift the debt ceiling.  It still expects a deal.  If the market is wrong and the government actually defaults, we can expect a rush for the exits and a big drop in stock prices.
Like most riveting arguments, both sides are right.  The President is right that no president should have to deal with a Congress for permission to pay the bills Congress has approved.  The Republicans are right that every tool must be used to restrain entitlement spending.  Because the President has already indicated some entitlement reforms he would accept, such as chained-COLA increases, I pray he will offer those entitlement reforms and cost savings now in exchange for permanently ending the harmful charade of debt ceiling negotiations, thereby sparing future presidents, both Republican and Democrat .  And, I pray the Republicans would accept that.  But, of course, both sides would find that solution imperfect!
I regret NOT teaching years ago that the world is NOT perfect, and that imperfection MAY not be all bad.

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