How to Make 2011 a Repeat of 1931

The US government is the largest purchaser of goods and services on planet earth.

The government buys everything from equipment for cancer research to metal for warships to toothpicks for federal cafeterias. Suppose the governmetn had to cut 44% from its budget on 2 weeks notice? How sharp a shock would that be to the world economy?

Here's a comparative. In the worst quarter of 2009, American consumers cut their spending by ... not 44%, not even 4.4%, but 1.2%. That 1.2% drop in consumer spending helped tumble the US economy into the worst collapse since the 1930s.

The US consumer sector is even larger than the federal government sector. But it's not unimaginably larger. US consumers spend about about $10 trillion a year. The federal government spends about $3.4 trillion.

If a cut of 1.2% from $10 trillion was an economic shock, a cut of 44% from $3.4 trillion will be a much, much, much bigger shock.

Yet a huge portion of conservative punditry this week amounts to a sustained denial of this seemingly self-evident arithmetic fact.

Here's an example from this morning's Washington Examiner.

Geithner could pay: the interest on the debt, all Social Security obligations, all Medicare and Medicaid obligations, all Defense contractor bills, all Veterans payments, and all active duty troops; and still have almost $7 billion left over for other items.

Yes, Geithner would still have to cut overall federal spending by 44%, and that would have economic consequences. But those consequences would not be as  bad as defaulting on the debt would be. Not paying civilian federal workers would be unpopular, but not paying active duty troops would be far more unpopular.

Not raising the debt limit would cause a limited government shutdown, not default, as Obama has been claiming. The reason why Obama has not been honest with the American people about that fact is because he wants to maximize their fear.

Now imagine that you are an information systems vendor with a contract to service the computers of the Social Security Administration. You have a contract worth $12 million a year. It's your single biggest contract.

Sometime around August 1, you receive word that the federal government will not be able to pay your contract. The government does not know when it will regain the ability to pay.

What do you do?

For starters, you sue. You may not be a bondholder backed by the full faith and credit of the United States. But you do have a legally binding contract, enforceable in a court of law. The money is owed and must be paid.

The second thing you do is you go to the bank to borrow some money to cover your payroll pending payment of the contract. Maybe the banker lends you the money. Maybe not.

If not, the third thing you do is lay off people. You're not being paid, so of course you cannot afford to pay out.

The fourth thing you do is try to cut other short-term costs. You test how long you can defer payments to your suppliers.

The fifth thing you do is begin to default on your own financial obligations: the mortgage on the office building, the line of credit that temporarily sustained your employment.

Now those suppliers face the same cycle of options as you previously faced: (1) litigate, (2) attempt to borrow, (3) lay off, (4) defer payments, (5) default on their own obligations. It'll be 1931 all over again.

The litigation piece is especially interesting.

If it's right that on Aug. 2, the federal government will have income of $140 billion a month to cover $300 billion of obligations, then we're going to see some scramble among the creditors, won't we? Those who move first will have considerable advantages.

What moves might they make?

They could for example seek court orders to attach any cash they can find belonging to the federal government. Republicans may wish to prioritize defense over non-defense vendors. It's unlikely that the courts will support that distinction. Republicans may want to prioritize Medicare vendors over non-Medicare vendors. Ditto, ditto. All will fight against all, and payments will flow in very random ways, but generally at a rate of 50 cents on the dollar.

If the situation lasts only a day or two, then we'll have a financial event with long-term consequences for US interest rates.

But if it continues for weeks or longer, then we'll have a real-world economic event, a massive demand-side shock sufficient to trigger a true global depression.

Perhaps it's true that such an event would be "less bad" than a straightforward debt default. That's hard to estimate. No question: it would be plenty bad enough. Harder question: why are conservatives - supposedly the party of business and the private sector - so sanguine about heedlessly provoking an entirely unnecessary crisis that will bear so hard on so many businesses and the whole private economy?