Why You Should Worry About a 'TARP Moment'

In debt-ceiling politics, it may be necessary to destroy the economy in order to save it.


Politicians are nice, rational folks. Really, they are. They just get a little worked up sometimes.

That's the message coming from official Washington these days as Republicans and Democrats play a game of chicken over the federal debt ceiling and, by extension, the entire U.S. economy. If the bickering pols don't agree to extend the debt ceiling by early August, it will prevent the government from borrowing any more money and toss the global economy into an unpredictable vortex. Washington relies on borrowing for about 40 percent of what it spends, which is obviously too much. But fixing that problem all at once isn't the medicine the economy needs, either. "A failure to raise the debt ceiling would cause financial markets to crack and trigger a new recession virtually overnight," writes economist Mark Zandi of Moody's Analytics. That's not exactly Congress's mandate.

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The long-standing assumption on Wall Street is that Washington politicians, for all their acerbic rhetoric, would never be crazy enough to willingly incite a recession. But they're starting to look a little crazier every day, especially as Republicans who control the House of Representatives refuse to accept any kind of tax increase as part of a debt deal. The brinksmanship is now forcing economists to start war-gaming the worst-case scenario: a refusal to extend the debt ceiling and the impact that unprecedented and abrupt spending cuts would have on the overall economy.

The result, some think, would be similar to the mayhem that developed in the fall of 2008, when Congress refused to intervene as the banking sector began to crumble. Many people forget, but before passing the huge bailout bill known as the Troubled Assets Relief Program, or TARP, the House of Representatives voted it down. That vote came on Monday, Sept. 29, about two weeks after Lehman Brothers collapsed and the whole Wall Street firmament began to topple. Stocks fell nearly 9 percent that day, which at the time was the second-largest one-day drop ever in the S&P 500 index, after Black Friday in 1987. Members of Congress who had been talking tough about bailouts and balking at TARP's huge price tag—about $800 billion—suddenly got religion. By the end of that week, Congress passed a slightly modified version of the TARP bill, which President Bush hastily signed the same day.

A similar storm could be brewing now. It would be disruptive at a minimum, and perhaps catastrophic, for Congress to force the government into a situation where it can't pay all of its bills. Congressional Republicans are using the threat of default to force deep spending cuts and shrink the size of government. A few prominent Republicans, like Rep. Michelle Bachmann and Rep. Paul Ryan, have even suggested that a temporary or "technical" default by the U.S. government wouldn't be that big a deal, and might help impose spending discipline. Economists see it differently. If the debt-ceiling were locked in place and the government had to immediately cut 40 percent of its spending, the Treasury Department would probably continue to pay interest on the debt, which accounts for less than 6 percent of all spending. So the government probably wouldn't default. Instead, it would close hundreds of government offices, furlough workers, curtail or cancel benefits paid to the unemployed, and delay Social Security payments, among other things.

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If that sounds like a useful exercise in fiscal discipline, consider that a 40 percent cut in government spending equates to 10 percent of GDP. Since GDP is growing at only a 2 percent annual rate right now, a cut of that magnitude would force the economy to shrink by more than it did during the entire Great Recession, from 2007 to 2009. And do it in one fell swoop. That scenario would amount to a "massive adverse shock to aggregate demand," according to investing firm T. Rowe Price. The self-inflicted damage to the economy could easily outstrip the economic effect of any earthquake, hurricane, tornado, or tsunami that's hit a developed nation.

That's why Washington would only let it happen for a few days, most analysts think. But that's dangerous too. If the U.S. government stops sending out checks, says Zandi, "stock and bond markets would face turmoil." Interest rates would soar, corporations would stop spending, and small businesses reliant on cash flow to stay in operation would face an urgent crunch. This is the "TARP moment" economists fear—and it wouldn't necessarily amount to a quick dip followed by an equal and opposite snapback once the politicians had made their point and raised the debt ceiling. Markets are notorious for overshooting, with fear often driving market reaction to extremes. If stocks plunge on fears of a sudden and sharp global recession caused by the fiddling politicians in Washington, banks could seize up too, refusing to lend even to their top corporate customers. In the meanwhile, speculators would run rampant and some investors forced to come up with collateral in a hurry would find they didn't have it. Once foreclosed upon, some would bear losses for good.

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The TARP moment in 2008 was followed by a sharp rebound in the stock market a few days later, when Congress finally passed the bailout bill that saved the banking system. But all the pieces didn't fall neatly back into place. The market rout on Sept. 29, 2008, shattered confidence in the nation's financial system and showed that a global financial panic, which many people thought was a relic found only in history books, is possible today. Banks lost the public trust, a reversal that's still evident in polls, consumer behavior, and the growing power of regulators.

Something similar would probably happen if there's a TARP moment in 2011. A stock-market panic might finally persuade dickering politicians to pass a debt-ceiling extension, so the U.S. government can operate normally once again. But there could also be lasting damage if it took a man-made crisis to accomplish a basic task of government. Confidence in Washington, already low, would go lower, which might be enough to trigger a downgrade of U.S. debt by rating agencies like Moody's and Standard & Poor's. That would raise Washington's borrowing costs, make the debt even larger, and signal that the United States is no longer the world's economic leader. Global corporations weighing whether to invest in the United States or someplace else would have one more reason—and a big one—to take their business elsewhere. Consumer confidence, already skittish, would fall further if Washington were to make the economy demonstrably worse instead of better.

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We may already be seeing preliminary signs of this year's TARP moment. Employers have sharply cut back on hiring recently, clearly worried about something bad happening in the economy. Many CEOs say that gridlock in Washington is one of the biggest uncertainties they face. Since mid-June, the price of credit-default swaps on treasury securities—essentially, insurance against a default--has been creeping up, a sign investors are getting nervous. And financial advisers have been telling clients to sell off some of the securities and commodities that would plunge in value in a crisis, while increasing their holdings of cash, gold, and other safe investments. The politicians in Washington may still forestall a meltdown at the last minute, patting themselves on the back for preventing a crisis they're creating in the first place. But pushing the economy to the brink of disaster is doing nobody a favor.

Twitter: @rickjnewman

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