Playing with Fire

Pennsylvania Senator Pat Toomey puts in his two cents as dumbest legislator early in his term. With Congress playing fire over a debt ceiling bill, he calls for legislation to only pay interest on the debt. As this article in the NYTimes notes:

“I think the important thing to do would be to make it clear to markets that the government is not going to default on its debt,” said Senator Patrick Toomey, Republican of Pennsylvania, whose bill assigns priority to interest payments. “It would be easy, I think, to make it clear to the markets that they don’t have to worry about this.”

Toomey's plan to pay interest payments but not other government obligations -- such as wages -- seems as dumb politically as economically. After all, much of the debt is held by foreigners, so Toomey would pay off the Chinese before American citizens who toil for the public. I guess this fits with the basic Republican idea that interest recipients are more important than average Americans, but it is certainly playing with fire to do so. This would convert the government into a debt junkie who chooses each month whether to pay utilities or the rent and which creditors to hide from. Does Toomey really believe financial markets will still trust US debt under such behavior?

Debt Reduction

John Geanakoplos and Susan Koniak have a nice op-ed in the New York Times that proposes a solution to the mortgage crisis. The key point is to focus on reducing principal rather than interest rates on mortgages where the borrower is underwater. Some great pictures in the article on how default rates are related to the extent a borrower is underwater.

The key point, I think, is that when you have a borrower who is insolvent you solve the problem with renegotiating the principal, not reducing the interest cost. The latter may deal with liquidity, but not insolvency. For the latter you need to make the borrower have an incentive to pay off the loan. That is where principal reduction comes in. They also show what their solution is cheaper than those considered by the Obama administration.