## Debt Ceiling Watch: Ezra Klein Makes a Mistake (Nobooy Knows Department)

He doesn't talk to any investors. Instead he talks to… the people at the rating agencies who brought us the subprime mortgage crisis: And so we get:

A small deal won’t cut it: There’s no longer much space to be creative, or incremental, or indecisive, on the debt ceiling. Perhaps there was two or three or four months ago. If we had raised it clean, or attempted the McConnell deal, or invoked the 14th Amendment, or gone for a series of short-term increases, that might have been enough. It isn’t now. Three months ago, all we had to do to keep the markets calm was raise the debt ceiling. Today, if all we do is raise the debt ceiling, there’s a very good chance the markets will turn on us anyway…. It’s about keeping the market confident in our ability to pay our bills, both now and in the future…. And Congress, unfortunately, has made that job a lot harder. A year ago, the market didn’t question our ability to raise the debt ceiling, nor our ability to come to a deficit deal in some reasonable period of time…. But we didn’t take their advice. We yoked the deficit to the debt ceiling….

And so the market reacted. Now the question isn’t simply whether we can raise the debt ceiling and pay our bills; it’s whether we can make the sort of tough choices necessary to pay our bills later. Standard Poor’s, for one, has sharply moved the goalposts. Now they say that if “Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden and are not likely to achieve one in the foreseeable future,” then they could downgrade us “in the next three months.”…

Simply increasing the debt ceiling might have sufficed a few months ago. It probably won’t now. That goes double for a solution relying on the 14th Amendment, which would add legal uncertainty to an increase in the debt ceiling and show that our broken political system has forced us into completely unprecedented and unpredictable territory. A short-term increase in the debt ceiling, as some Republicans have called for, is also likely to affirm the market’s fears that we can’t make tough compromises.

The market did not tie the debt ceiling to a $4 trillion deal on the deficit. Washington did. But now that it’s not clear that Washington can get the deal, the market may not let it undo the knot. And: Ezra Klein: Earlier today, I spoke with David Beers, director of Standard Poor’s sovereign debt department. He explained that it wasn’t economic factors that had put America’s credit rating at risk, nor world events. It was credit-rating agency’s increasing fears that our political system was no longer up to the challenges that face it. “What we’re saying now,” said Beers, “is we question whether despite all the discussions and intense negotiations, if they can’t reach this agreement, will they be able to reach it after the election?” If we convince Standard Poor’s that our political system has failed, they will downgrade our credit within three months. If they do that, interest rates on our debt will spike, perhaps by 50 basis points, perhaps by more. An easy rule of thumb is that if interest rates rise by 50 basis points, we will lose 600,000 jobs in this country. At this point, there are three serious options on the table. A$4 trillion deal that includes some revenues, a $1 trillion-$2 trillion deal that’s all spending cuts but leaves much of the job until after the election, and a deal in which Republicans don’t come to a negotiated agreement with President Obama but they grant him the authority -- and let him take the blame -- for raising the debt ceiling. Those are our three options, and Congress needs to pick one. Time is running short.

But there are more very serious options than those three. There is the very serious option of passing a clean increase in the debt ceiling. Or there is the very, very serious option of the Treasury declaring the debt ceiling a dead letter. And then there are the other, more amusing options as well.

The simple fact is that the markets have not linked the short-run debt ceiling debate to America's long-term fiscal imbalances. The markets have not yet judged the U.S. and found it wanting. Ezra shouldn't say that financial markets have done these two things when they have not.

The fact is that nobody knows what will happen to the Ten-Year Treasury yield if S&P downgrades the U.S. credit rating.

1. The interest rate on the Ten-Year Treasury bond could spike.

2. The interest rate on the bond could even fall--more chaos means a weaker global economy, and in a weaker global economy in the absence of inflation you should be holding more U.S. Treasury bonds, not fewer.

3. The interest rate on the bond could stay where it is, as the two types of fear offset each other.

4. The interest rate on the bond could stay where it is as markets laugh at S&P's chutzpah, at the institution that claimed that MBSs were safe now claims that U.S. Treasuries are risky.

5. Demand for U.S. Treasuries could fall, but the yield could stay the same as some other large actor--the People's Bank of China or the Federal Reserve--steps in and buys long-term Treasury bonds in order to sataiblize the market.

I have talked over the past two weeks to at least one investor with substantial positions who himself is confident that each of these is the likely possibility.

The future is wide open.

Uncertainty is massive.

Now we should not be doing this. Doing things that have unknowable and quite possibly disastrous consequences is the very definition of stupidity. We should resolve the uncertainty today. And the only way to resolve the uncertainty today is for the Treasury's General Counsel to declare the debt limit a dead letter--implicitly repealed by a combination of Amendment 14 §4 and the Continuing Resolution appropriating spending through September 30, 2011.

But confidently speaking about what will happen in financial markets after talking only to regulators and politicians and not by talking to financiers and watching prices and volumes…