The Debt Ceiling as a Bargaining Chip

How bad will it be if we don’t manage to raise the debt ceiling in the United States? And what should President Obama’s negotiating strategy be? A few thoughts.

The direct effects of hitting the ceiling would be bad enough — sharp cutbacks in spending, which would undermine essential services, not to mention derail the economy. It’s not clear to me whether there would be some wiggle room through the accumulation of arrears — say, not actually paying workers and contractors, but promising to make it up when sanity returns. But it would be ugly indeed.

What might make it even worse would be indirect effects, of two kinds.

First, government debt plays a special role in the American financial system: Treasury bills are the universal safe asset, the ultimate collateral. That’s why, during moments of financial stress, the interest rate on T-bills has actually gone negative. Make that safe asset suddenly unsafe, and it might cause vast disruption.

Second — and I don’t think this is getting enough attention — failure to raise the debt limit could act as a terrible signal about the American political system.

When you look at the United States’ fiscal position in terms of what we’re capable of as a nation, it’s not a big problem. Never mind those big numbers you hear about implicit liabilities; we have a big economy, too. So modest tax increases and reasonable efforts to limit health-care costs could bring our long-run finances into line.

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But all this depends on our having the political will and cohesion to do what’s necessary. What if it turns out that we’re a banana republic, with crazy extremists having so much blocking power that we can’t get our house in order?

And failing to raise the debt limit could be widely read as a signal that we are, in fact, a banana republic. In that case, however, what should Mr. Obama do? My answer is that he must not let himself be blackmailed.

Partly that’s because once he gives in the first time, the blackmail will never stop. Once the crazies know that they can get whatever they want by threatening to blow up the economy, they’ll just keep demanding more and more. Mr. Obama can’t let that dynamic get started without setting up an even worse crash down the road.

Plus, the conservatives on the far right may claim that they’re worried about deficits, but they’re actually deeply fiscally irresponsible. Realistically, the budget-deficit plan conceived by Republican Representative Paul D. Ryan would sharply increase the deficit — because its spending cuts are in many cases impossible, and its supposed revenue neutrality is a sham. So giving in to the right would be just as much a signal of banana-republic-hood as a temporary default.

This is going to be very ugly. But I don’t think there’s any way to avoid taking it all the way to the edge, and possibly over it.

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including “The Return of Depression Economics” (2008) and “The Conscience of a Liberal” (2007). Copyright 2011 The New York Times.