Goldman Fires The Second Shot Across The QE3 Bow: "Successful Fiscal Consolidation Needs Monetary Policy Help"

Tyler Durden's picture

Yesterday, when we presented the Bloomberg interview of Princeton economist and former Fed vice chairman Alan Blinder, we speculated that his statement that "more easing is necessary" was the first shot across the QE3 bow. Today, Goldman's Sven Jari Stehn has fired the second one in a paper just released titled: "Fiscal Adjustment without Fed Easing: A Tall Order" in which he basically takes our conclusion from the Blinder interview to the next level. As Blinder said previously, in order to improve the once again deteriorating labor picture, more fiscal stimulus would be necessary. That, however, is impossible, especially in a Congress where everyone is now promising $4 trillion of deficit cuts over the next few years. The only difference is how this cutting will be achieved: republicans want spending cuts, while democrats are demanding tax hikes for the richest. While neither approach will work in the US without the shock of a bond-crash induced austerity, Goldman conducts an thought experiment in which it evaluates the effectiveness of a tax-based and a spending-based fiscal consolidation. While finding that on average spending based deficit reduction is more effective, it only truly works in parallel with assistance from monetary policy: be it an interest rate decrease (impossible due to ZIRP) or further Large Scale Asset Purchase (QE) program. In other words, the only thing that can prevent an economic contraction in the next 2 years of semi-austerity, will be more monetary easing.

Furthermore, Goldman also openly admits that in either fiscal case, the drag on economic growth will be substantial. "A number of studies have shown that adjustments focused primarily on spending cuts (“spending-based consolidations”) tend to be notably more successful at delivering such large consolidations than revenue-based ones. Building on work done by the IMF, we identify two reasons for this difference. First, spending-based consolidations are usually more persistent, as they are often combined with structural reforms. Second, spending cuts tend to be less damaging for growth than tax increases...A key factor behind this difference in success, however, is the response of monetary policy. While spending-based adjustments are typically accompanied by monetary easing, tax-based ones often see monetary tightening. Using a counterfactual experiment which “shuts down” the interest rate response, we show that the difference in growth damage between spending and tax-based adjustments narrows sharply..With the funds rate close to zero, our analysis implies that both spending and tax-based consolidations are likely to act as a significant drag on growth. Nonetheless, spending-based adjustments might still be the lesser of two evils, particularly if combined with entitlement reform and fiscal rules that come with a strong enforcement mechanism." Translation: the economy will slow materially regardless, but without monetary easing it will crash. Next up: cue an enjoinder by the New Jersey installment of the Ivy League, and the balance of Wall Street, all of whom realize that their bonuses are suddenly at steak.

We said yesterday that "we believe that with this the opening salvo for more cash demands, which will be met with staunch opposition in D.C., thereby kicking the ball back to the Fed (which already is doing everything in its power to deflate all commodities as rapidly as possible - a trend which will sooner or alter engulf risk assets as well) the only alternative is monetary. Aka more quantitative easing. And when that becomes apparent, and when Goldman's Jan Hatzius is firmly on board, the full court press for another round of easing can begin." Well, Goldman just got on board. Look for the cries for more monetary intervention courtesy of a Congress which can't make up its mind about a debt ceiling hike for 4 months to escalate over the next 2-3 months as the economic reality turns aggressively south. At that point the Chairman will be faced with a daily barrage of "experts" who are screaming "deflation... or printing." We have a guess which one Ben will chose.

From Sven Jari Stehn of Goldman Sachs

I. Fiscal Adjustment without Fed Easing: A Tall Order

The US needs a very large fiscal consolidation as we expect a primary (ex-interest) deficit of 7.7% of GDP this year. Stabilizing the debt stock eventually requires the primary budget to be close to balance. Although some of this deficit is cyclical, the structural deficit (defined here as the primary deficit adjusted for the cycle and one-off accounting changes) currently stands at 6% of GDP. Moreover, this is the  very minimum adjustment needed as stabilizing the debt stock at current levels—or even returning the debt ratio to pre-crisis ratios—would require a much larger fiscal consolidation.

Ingredients for a Successful Consolidation

A number of studies—going back to Alberto Alesina and Roberto Perotti in 1995—have identified factors that determine the “success” of a  fiscal consolidation,  which is typically defined as a sizable and lasting reduction of the deficit or debt ratio.

The key result of these studies is that spending-based consolidations tend to be much more successful than revenue-based ones. There are two suggested reasons for this result. First, these studies argue that spendingbased consolidations are usually more persistent because they are often accompanied by structural reforms. Also, spending-based adjustments tend to be politically more difficult and thus signal stronger commitment to continued fiscal consolidation than tax increases. Second, these studies find that spendingbased adjustments are less detrimental to growth—and indeed can boost growth. The better growth outcome eases the consolidation burden both directly (through higher tax revenues) and indirectly (because it makes it easier to sustain the adjustment).

Recent work by the IMF, however, suggests that these conclusions should be re-examined. First, the IMF has shown that all consolidations—whether spending or revenue-based—tend to act as a drag on growth when we look at intended consolidations (or consolidation efforts) directly instead of the resulting changes to the structural deficit. In particular, the IMF argues that existing studies “stack the deck” against finding significant adverse growth effects. By using the cyclically-adjusted budget deficit to identify fiscal consolidations, the earlier studies include episodes that were not genuine periods of adjustment but rather one-off accounting changes. Moreover, even when such one-offs are removed, the change in the structural budget deficit is often a poor proxy for deliberate changes in fiscal policy because it fails to detect attempted fiscal adjustments that result in sharp downturns and are therefore reversed quickly. Second, the IMF study suggests that monetary policy plays an important role in shaping the consequences of fiscal adjustment. Specifically, spending-based adjustments have a less detrimental growth effect than tax-based adjustments because they are, on average, accompanied by monetary easing while tax-based adjustments usually see monetary tightening. This suggests that the success of a consolidation in reducing the deficit or debt ratio might depend importantly on the monetary policy response.

Finally, the new IMF dataset allows us to explore to what extent intended adjustments actually result in expost improvements in the fiscal situation. That is, the dataset enables us to take into account that a consolidation attempt might have been so badly designed or implemented that

Spending Adjustments Are More Successful...

In an initial look at the IMF data, we organize the dataset into consolidation episodes. Specifically, we define a consolidation period as one in which policymakers intend to consolidate by at least 1% of GDP in the first and last periods. This definition produces 29 episodes of consolidation.

We then split these episodes into the five consolidations that produced the largest and smallest improvements in the primary balance.  Exhibit 1 shows how effort and success vary across those two groups. Exhibit 2 lists details of these episodes. The two exhibits offer a number of interesting insights.

First, the required US adjustment is comparable only to the largest three consolidations in the dataset. Only Denmark starting in 1984, Sweden in 1993 and Ireland in 1982 have achieved consolidations in excess of 9% of GDP. Moreover, the most successful efforts were much more persistent than the unsuccessful ones (6 years on average versus 1 year).

Second, there is notable slippage between the adjustment effort and the actual improvement in the primary balance. During the least  successful  consolidations, the average adjustment effort (an average 1.5% of GDP) resulted in no improvement in the primary balance (Exhibit 1). But even for successful consolidations, the average adjustment effort (13.1% of GDP) was quite a bit larger than the reduction in the primary deficit (8.9% of GDP). One source of slippage is that the consolidation effort is only partially passed through into  improvements in the structural deficit—most likely because some consolidation efforts were aborted before the fiscal outlook actually improved (e.g. Japan in 1997).

Another reason for slippage is the effect of the consolidation effort on growth, as discussed below.

Second, the exhibits confirm earlier  studies that successful consolidations rely much more on spending reductions (around 72% of the adjustment) than unsuccessful ones (37%).

Finally, we see that the most successful consolidations, on average, saw no decline in growth while the least successful ones experienced a sharp 2.7 percentage point (pt) drop. At the same time, however, the top adjustments were accompanied by notably more monetary easing than the failures. During successful consolidations policy rates fell, on average, by 5.5pts while they only declined by 1.1pts during the least successful consolidations.

… Mostly Due to Monetary Policy

Given this very different response of monetary policy, we now explore the extent to which this drives the differences in success. To do so,  we estimate a statistical model for the 15 countries between 1980 and 2009 that explains the joint dynamics of the IMF’s measure of intended consolidations, real GDP, the primary balance and the monetary policy rate. Once estimated, we use the model to trace out the effects of an intended consolidation on growth, the primary balance and the policy rate. To distinguish between the effects of spending and tax-based consolidations we estimate two additional models and plot the results alongside the average consolidation.

Exhibit 3 shows how the primary balance, on average, responds to an intended fiscal consolidation. Consistent with the evidence above,  our estimates imply that a 1% of GDP consolidation effort typically improves the primary budget by only half that amount. Moreover, Exhibit 3 confirms that spending-based adjustments tend to be notably more successful in raising the budget surplus than tax-based ones. The reason is twofold. First, spending-based consolidation efforts tend to be sustained for longer than tax-based ones. Specifically, a 1% of GDP spending adjustment effort is usually followed by an additional spending cut effort of 0.4% in the year after, while a comparable revenue adjustment is only followed up with another 0.1% of GDP tax raise. As a result, spending-based adjustments raise the structural balance by almost twice as much after five years than tax-based adjustments (not shown).

Second, spending-based adjustments are less damaging for growth (Exhibit 4). Consistent with the IMF study we find that a 1% of GDP consolidation effort, on average, reduces real GDP by around ½% after two years. The composition of the adjustment, however, matters crucially: the GDP hit is much larger for tax-based consolidations (around 1½%) than spending-based ones (¼%).

A notable difference between spending and tax-based adjustments, however, is the response of monetary policy (Exhibit 5). The former are accompanied by monetary easing, while tax-based adjustments typically see monetary tightening in the first year (followed by some easing in the second year). The IMF shows that the initial monetary tightening is driven by interest rate hikes in response to indirect tax increases. A likely explanation is that central banks are worried about second-round inflation effects from increases in indirect taxes.

Consolidating Without Monetary Policy

Taken at face value, these results suggest that spending cuts are an overwhelmingly more attractive option than tax increases: they tend  to be more  persistent and less damaging to growth (although they don’t raise growth as suggested by some previous studies). Applying this conclusion to the required US adjustment, however, would be naïve because the  above results likely overstate the success that can be expected from spending-based adjustments relative to tax-based ones in the current environment. With the funds rate close to the  zero lower bound, a spendingbased adjustment could not be accompanied by monetary easing unless the Fed decided to adopt another asset purchase program (which we think is  highly unlikely). Moreover, the Fed would most likely see through any indirect tax  increases—were they to occur—and probably not raise interest rates in response to a revenue-based consolidation.

In a counterfactual analysis we therefore attempt to “shut down” the interest rate response to get a better sense of the implications of the choices the US currently faces. Such an experiment is fraught with difficulty as it requires an estimate of how changes in the policy rate affect output and the budget deficit. To obtain such an estimate we proceed in two steps. First, we use quarterly data to estimate the  effect of shocks to monetary policy on growth and the primary pioneered by David and Christina Romer. Second, we transform these estimates into annual data and apply them to the cross-country results above to construct the “no monetary policy” scenario. Given these steps, the uncertainty surrounding the resulting simulation is substantial. Moreover, allowing no monetary policy response is an extreme assumption as Fed officials could adopt additional unconventional policy steps to support a spending-based adjustment if they chose to do so.

With this in mind, Exhibits 6 and 7 suggest that the difference in success between spending and tax-based adjustments is less pronounced when there is no monetary policy response. In particular, the hit to GDP is now more similar during the first two years, at 1-1½% for tax and spending-based adjustments. After the second year, however, spending-based adjustments are still quite a bit less damaging to growth. As a result, the achieved improvement in the primary balance is now also more similar across spending and tax-based adjustments during the first two years. A 1% of GDP consolidation effort now improves the primary deficit ratio by half that amount after two years regardless of the composition. Spending adjustments, however, remain more effective at reducing the deficit persistently.

Spending Cuts are No Panacea, but Necessary

Our analysis implies that even spending-based adjustments are likely to be challenging in the current environment. This is because without  a monetary response, both spending and tax-based consolidations are likely to act as a sizable drag on growth.

That said, our analysis suggests that spending-based adjustments are nonetheless likely to be the lesser of two evils. First, the difference in growth damage between spending and tax-based consolidations narrows sharply without monetary policy but remains noticeable three or more years after the start of the adjustment. Second, spending adjustments tend to lead to more persistent deficit reductions than tax increases. This is probably because such consolidations often involve entitlement reform and not just one-off reductions in discretionary  outlays.  More broadly, this highlights the desirability of multiyear fiscal rules that come with a strong enforcement mechanism.

Meanwhile, barring another round of asset purchases, the best the Fed can do is keep monetary policy on hold to cushion the growth drag from the fiscal  consolidation—independently of whether it comes through adjustments in spending, revenue or both. As a result, the looming fiscal adjustment should reasonably be expected to see policy rates—and probably longer-term rates too—at lower than normal levels for an extended period.

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NOTW777's picture

LOL another summer of recovery - millions of obama jobs - trust us

"deteriorating labor picture"  what - thats not what steve liesman said

Creed's picture

I've been cautious, not buying the dip here...


Al Gorerhythm's picture

I read something interesting in Tyler's post,

One of his asides; "If there is one margin hike we approve of it is for the CME to hike the margin to 1000% cash in trivial common sense BS." struck me as prescient.

Are the CME hikes a reaction to the possibility of $US default, rather than a COMEX default? There is a possibility that it could be both, which means that all  gold and silver will sell for full price, possibly immediately.

Think of the implications if Ron Paul becomes president as well! He has an open agenda to end the FED and abolish the IRS. He is going to have battles with giants who have a lot of people reliant upon the status quo. 

All of these issues are directly related to the PM complex. I think that if the US defaults, gold and silver/ US dollar ratio will be re-rated until their true valuation of paper is exposed.

Silver is the only commodity in the world that you can still buy at a discount to its 1980 peak. Every other commodity has left their 1980 paper price behind, in this bull market.

Silver is on fire sale, thanks to the selling pressure of major parties, who have an economical interest in keeping it low. What metric you use to establish fair value is the hard question to answer. Whatever your metric, the nominal  paper equivalent is stratospheric.

Jump in, the water's fine! 

traderjoe's picture

Argh...Ron Paul will never be allowed to be President. It's much more likely that he is controlled opposition. He's been in Congress for over 30 years. Think about that. 30 years. 

Everybody wants a savior. There are no saviors. There is no cavalry. 

"We" are our only hope...

Careless Whisper's picture

Chairman Bernanke confronted by a real journalist; refuses to answer questions at party. Politely tells journalist to fuck off.


jeff montanye's picture

imo the most amusing part of the whole charade is the current hand wringing over the deficit that now must be cut during the first end of credit cycle deflationary depression in eighty years.  

that would be the same deficit that most of the administrations of the twenty five year expansion (1982 to 2007, with precious little exception) increased during a time of relative prosperity.  

got to laugh to keep from crying.

tarsubil's picture

That kid is going to disappear.

traderjoe's picture

He's not even a pimple on their ass. 

Here's my personal favorite BB moment:

dark pools of soros's picture



they are all in love with the debt is money banking system to even think about prior economies

falak pema's picture

Oh well, here we go back to the Gen. Jackson Days....with a vengeance...

Troll Magnet's picture

what a moron this guy is. he corners bernanke and the only question that comes to his mind is some conspiracy drivel bullshit?
idiots like this are totally counterproductive and make every sane person who objects bernanke's actions look bad. shut the fuck up and get a real job, you fucking retard!

Al Gorerhythm's picture

I take issue with your assessment.

This kid has the balls and the gumption to walk up to a high powered "official", got off his ass and confronted him over issues that he felt important. He took action and all you have is a basement generated statement, deriding his questions. If you have other questions that you would like to have answered, get off you fat, condescending ass and go out and do the same. You will come up with some excuse, no doubt. 

Good on the kid. He is a patriot and a trier. It shows that the young folk aren't all asleep. That is heartening. You however need to pick up your game. 

What are your questions that you would ask of Bernank. List them big shot. Gutless cunt that you are will only take pot shots at the guy from behind a soubriquet.

I've got two more things to say Go Kid and Fuck You. Someone else is doing your dirty work and you give them a broadside. Fuck you. 

Bobbyrib's picture

If anything this kid is weakening the fight against Ben. His questions were not well thought up at all. As I said in my other response: this dumbass makes himself look like a toolbag when he tried to act smart.

Bobbyrib's picture

Thank you for sayin this. I agree with you. My favorite part of the video was :58 when security starts pushing him out the door. You could see the Bernank roll his eyes at the kid after he asked he asked about the 2008 Bilderberg meeting. Also he asked about what Ben has done to the economy. IMHO, he should wait one to two years when the real inflation kicks in to ask Ben that question.

Stupid people look like total toolbags (backward Yankees cap) when they try to act smart and rant about topics they know nothing about. Nothing will happen to this kid, if I were Ben I would hire this kid to ask me stupid questions to make it look like the Tinfoil Hat Brigade was getting anything done.

Al Gorerhythm's picture

Oh yeah, Right. We should all wait for a few years and watch the world as we know it burn. Another go getter. Let me say this in the nicest possible way.......Fuck you too, champ. Dear oh dear, he had his hat on backwards!

Farcical Aquatic Ceremony's picture

I don't subscribe to his theories either, but at least the kid is doing something, which is more than our sorry asses have done this week.  Good for him.  Glad to see young people getting it, even if they don't have it figured out 100%. Inspiration, to me.

vipobviously's picture

People say a vote for him is like "throwing away your vote" because he "cant win." I say voting for the lesser of two evils is still voting for evil. Thats throwing away your vote IMHO.  If everyone disregarded all the crap spewed from one of our six news empires that own every station and voted for the candidate they wanted to have represent them, its possible we could restore this republic without the bloodshed inevitable in a "walking dead"democracy

DaveyJones's picture

I say never vote for either party ever again. Destroy them before they destroy us. Well said trader

tarsubil's picture

This is the most cynical and from my experience rings true. Little by little I'll prepare for what now seems inevitable. What a wake up call this is going to be for people.

in4mayshun's picture

Silver on sale! If only I could get me some zirp FED money

Quixotic_Not's picture
Successful Fiscal Looting  Needs Fed Monopoly Policy Lies!
rocker's picture

I almost put a heavy short on today. But in the grand scale of things I don't trust TBTB. Everything is so manipulated at this point. I think I will just buy more PM's from Apmex instead. At least it is real and we do have a pull back. Can't believe reality says they are a good buy and cheap at these levels. Ben needs to print and keep GS bonus's high. Since the integrity of GS is less than Bernie Madoff at this point.  Will someone please make Lord Blankfien and Bernie room mates. 

traderjoe's picture

IMHO, Apmex premiums have gone up significantly. Tulving (if you can get past the minimums) are more reasonable. And there is always the local coin shop (good to develop a relationship with them)...

rocker's picture

@traderjoe  If you come back to this and I will check. May I assume that you have done business with this company. Have not ever heard of them. Price is what it is all about as long as everything is up to honest standards.

Trust is most important with precious metals.  Thanks for the tip. Am checking out tonight.

traderjoe's picture

Yes, I have purchased from them a few times. They seem sort of mom-and-pop, but they deliver promptly and I've never had any problem with them. 

And just as an FYI - never do business with Northwest Territorial Mint. 

rocker's picture

Thanks much to both. 

Eireann go Brach's picture

QE3 is a certainty because Obama will never let the economy sink back into recession while 2012 election year is around the corner, so yes it is 100% possible that one selfish bastard can put his own individual re-election needs ahead of the needs of 350 million citizens, because when shit truly hits the fan in a few years, he will be doing book deals and getting paid $200k a pop to show up and read from a teleprompter on the after dinner speech circuit!

rocker's picture

This is not about Obama. Please leave politics out of it. This is about the FED and Goldman Sachs. Read the fukn article. Goldman fires the second shot. If you want to put politics in it. Try this. Goldman donated more to Republicans. Enough said on that point. Is Bambi another Puppet, yes. Just like Bush was and all the others. Bush gave medicare a big bonus without paying for it. Bush pumped the phony war without paying for it. His tax cuts provided how many jobs. Was that 6 million. Are we not told that Tax cuts create jobs. LOL. Leave politics out of it. Even Ron Paul is softing on the FED. Hmmmmm.   

Reality is, this is about the banking cartel called the FED devaluating the dollar again. The hidden tax on the middle class and the poor. Which will put us in a real depression one way or another at this rate.

Jack Burton's picture

+ infinity!

It is about the banking cartel that rules America. Political parties are a pupptet show. Does anyone seriously believe that Democrat versus republican crap?

rocker's picture

I do not. I think both parties are whores for the puppet show.  Those who run the show accomplish what they want.

Divide and conquer the sheeple.

DaveyJones's picture

You got it Rocker but it seems even worse. There is not one area of the economy not one industry that is not ruined due to corruption and capture. We are a second rate country with third world principles and first world weapons.

Oh regional Indian's picture

Priceless, though as a Third Worlder, I take offense at being compared to America.

We are rather principled, with-in our own moral code, if you know what I mean. ;-)

Well said though. We are all in the same boat. Regulatory capture, fiscal capture and belief capture...they've pretty much got 98% of the global capitalist "Economy", macro by the short hairs...


slewie the pi-rat's picture

careful, there, ORI!  don't let that neo-colonial third world thingy take over, ok?  LOL!  it might detract from you overall advertising message, here!  old chap...

whstlblwr's picture

Jack Burton say: "It is about the banking cartel that rules America. Political parties are a pupptet show. Does anyone seriously believe that Democrat versus republican crap?"

Or is it about Big Oil cartel.

bmwm395's picture

All good points. But you can't take politics out. It's a big piece of the puzzle.


I am a Man I am Forty's picture

both wrong, this is about congress, they are the ones with the power, they give the fed their power and are the ones who have to raise the debt ceiling

Bay of Pigs's picture

Get real. Congress? Those pathetic bastards were bought off decades ago. Of course they will raise the debt ceiling. Where ya been? Since WWII, 80 times and counting...

tickhound's picture

Congress?  Government is the sideshow

Arius's picture

does that mean i should not write my congressman to goddamn fix it....or else ?

NOTW777's picture

rich - you tell him to leave politics out of it and then spew your politics

if you want to parrot the bumper sticker that "every politician is the same" that is your trite choice.  likely you cant come to grips with your vote for obama

its naive to think politics plays no part

TheTmfreak's picture

The common assumption that seems to be made is "they are all in on it." I think an appropriate way to look at it is "they're all trying to be the one who comes out on top." 

Just like mafia families. And when someone is no longer useful, they'll throw them under as well.

Clowns on Acid's picture all about Obama...and GS contributed more to the get your facts straight, and then come back and give a humble opinion....if you can.

GeorgeHayduke's picture

You point out the usual Republican trick and the disillusioned sheep still junk you because they can't accept that the two party system is a scam. They just love hating those other guys so much because it has to be them causing all of the problem.

Good points about Bush. He had a Republican house and senate for 6 of his 8 years in office, yet the seething Reich-wing radio pundits STILL blamed Dems and "Liberals" for eveything and anything bad that happened. Obama promised to end both stupid-assed wars, close Gitmo, etc...and here we are with no change whatsoever. How much more evidence do we need that neither party has any agenda beyond that of their owners?

BTW, you point out the #1 Rethuglican issue that makes me pick on them much more than the non-rethugs: hypocrisy. Rethuglican arrogant hypocrisy and their inability to see it knows no bounds. I always love how they claim to be the party of fiscal responsibility when their trick, since Regan, has been to lower taxes, borrow and spend more (at interest), and shove the whole mess off on the next administration and future generations. Then, they act as though they are morally superior for doing so! And their sheep buy it!! HAHAHAHA! Sure the Dems are as bad, but at least they don't give you all this religiously righteous, arrogantly superior, morallity bullshit as they rob you blind.

Okay Rethug sheep, you may now junk away. I's easier than thinking or looking in a mirror ans actualy seeing.

whstlblwr's picture

It's right both party fucked up. Stupid GOP go back to same issues where they lose, because they make money with it in primary. Money out of politics is most important issue. I don't want government in personal life. If GOP believe less government, why they legislate abortion, or give tax money to rich oil? I laugh when Boehner weep that gas price high because need to drill in US park. They raise money from BIG OIL when say that.

Some of you on here at ZH could run for office this election without money, and we elect you. There are enough of us to beat the money. You run, we help you win. You won't compromise.

InconvenientCounterParty's picture

When you've reduced the world, and yes it's a big complex world, into a binary; "us" and "them". You've been captured and are a slave.

bad sheep

Urban Redneck's picture

QE3 is a certainty at some point in the near future because if the US public debt, which is currently financed at near 0% for the majority of the balance and which lies predominantly at the short end of the curve, had to be refinanced at a 0% real interest rate, then the nominal amount of interest payments on the existing public debt would rise hundreds to thousands of percent, and collapse the house of cards.