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Government Shutdown: Rx of the Devil or Just What the Doctor Ordered?

A conversation this morning with a centrist Democrat from the Brookings Institution who lived through the shutdown of 1995, economist Martin Baily.

“In terms of the economy, it had a surprisingly small effect,” he said. “On the other hand, when they did it last time, the economy was growing strongly. Now, it’s much more vulnerable to a shock. But I would be surprised if a government shutdown did much damage to the economy, if it’s just for a few weeks.”

There will be plenty of inconvenience, Baily quickly added.

“All the people coming to D.C. in April to go to the Smithsonian are going to be p-ed off. So are government workers who won’t get paychecks. Last time: they paid the government workers eventually.”

But if they don’t pay this time, Baily acknowledged, the pay lost during the shutdown will wind up being a furlough and could have an income effect on GDP, since government is such a big player in the economy.

“If it becomes a much longer struggle, it’s a different story. But that seems unlikely.”

What might it do to consumer confidence? I asked. What might it do to investor confidence, i.e., the confidence of investors who we rely on to buy U.S. bonds? Baily foresaw negative effects on both.

“If you see Congress playing chicken with this issue, you’re worried they’re a bunch of crazy people who will play chicken with the debt ceiling, raising the possibility of default. I don’t think the U.S. government is going to default on its debts, unlike Portugal, Greece and Ireland.”

But a drop in investor confidence would mean the U.S. is forced to offer higher interest rates to attract bond buyers.

“If interest rates rise significantly,” said Baily, “it’s going to cost more and more to service the national debt. That means less money for everything else. It’s a scary scenario.”

How does this compare to the last shutdown, when Baily served on President Clinton’s Council of Economic Advisers?

“In the ’90s, the economy was stronger; the debt and deficits, much less of a problem.”

Baily doesn’t see foreign bondholders panicking yet, but they could, he said, citing a recent remark by Republican economist Douglas Holtz-Eakin that U.S. Treasuries are “the favorite horse in the glue factory.” (That is, European or Japanese bonds are even less attractive.) “But that doesn’t mean you can ride it for another trillion dollars and expect it not to break down.”

“You don’t know where the tipping point is going to be,” is how Baily put it. “I don’t think we’re right on the edge, but you don’t know.” The edge of a flight from the dollar and U.S. bonds that has so long been feared, has for so long failed to materialize.

But the most noteworthy – or, perhaps, “newsworthy” – aspect of our chat came at the end: the potential upside of the shutdown.

“One possible effect is that investors interpret this as the first real thrashing around that something’s got to be done about the deficits.:

The government was shut down by Republicans in 1995. And yet…

“Lo and behold, we did have surpluses by 1999,” says a Democrat who decried the shutdown at the time.

“You could interpret this as the beginning of sanity. But on the other hand, we’re so far apart, and the Republicans are going after women and children, renewable energy, the IRS (they don’t want to collect taxes), state and local law enforcement, land and water conservation, instead of raising taxes, which any serious deficit reduction plan has got to do.”

But last time, eventually, not only was spending restrained; taxes were raised.

So this time, perhaps investors will remember the past and decide that “Congress is serious,” that our deficits and cumulative debt are finally on the road to restraint. In that case, interest rates could go DOWN; the dollar, UP. Assuming, concluded Baily, that a political compromise is reached in a triumph of economics over ideology.

Additional editing revisions were made to this entry after its original posting.

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