The United States is now officially playing with fire with regard to its debt. On Monday, the government borrowed as much as legally possible and can no longer issue more debt to fund expenditures. The Treasury is now taking extraordinary measures to stop the country from defaulting on its obligations. The government can play creative accounting for a few more months. However, sometime in August, several tough choices will have to be made, and some checks will stop going out.
This is of course a political crisis more than it is an economic crisis. The debt ceiling is an arbitrary limit set by Congress, and Congress has the power to raise the ceiling to accommodate additional debt issuance. But the issue has become a political wedge that both sides are trying to exploit for political gain. Republicans want any increase to be paired with their vision of how the budget should be cut, while Democrats want it raised with no strings attached or with their cuts attached.
It is hardly a radical statement to say that a US debt default, or even a whiff of a default, could be devastating for investors. But of course no one knows for sure exactly what would happen because there is no real precedent in US history. It is this very uncertainty that makes the prospect of tripping the debt ceiling scary.
The federal government is spending more money than it is bringing in. That is the reason we are in this bind, and it is a real problem. A long-term solution to bring the budget into balance (likely through a mix of cuts and higher revenues) is needed to keep this from becoming a true economic crisis. But the negotiation to find a real solution will be made all the more difficult with the debt-ceiling crisis hanging over legislators' heads.
So far, the market believes that this political struggle will end in an agreement. Treasury yields have barely budged, and there isn't a sense of a crisis in the market. This faith that it will all work out is likely because in the past it always has. Many impasses aren't settled until the last minute (see the government shutdown averted earlier this year), and investors are betting that this one will also eventually get solved. And the fact that the Treasury can use extraordinary measures-- such as tapping sources like the exchange stabilisation fund for cash to extend the date of default--has also created some breathing room. The market may very well be right, and Congress might find a solution. But it is still worthwhile to make some guesses as to what the consequences of truly breaking the debt ceiling would be.
Cost of Borrowing Soars
The US government is able to borrow at rock-bottom rates because investors assume there is almost no chance they won't get their money back. Any sign that the return is not 100% guaranteed is going to send rates much higher. There will be a demand for higher returns as the perceived risk of not getting paid goes up.
And it is the perception of the risk that truly matters here. Even after the debt ceiling is broken, investors will more than likely continue to receive their normal interest payments for some time. It's a good bet that money that was previously destined for other federal programmes will be diverted to make interest payments on the debt. But that couldn't go on forever, and, to investors, it could indicate that the government doesn't have the will to make the changes needed to secure the existing debt.
How much rates would rise is an open question. There could very well be panic, but at home and abroad, many investors hold huge amounts of money in the Treasury market that couldn't be moved out of the market that quickly. US Treasuries constitute the deepest and most liquid fixed-income securities market, and there isn't any obvious place for that money to go right away. Euro-denominated bonds hardly look like a safe haven, and emerging-markets countries with great growth potential generally have limited debt markets.
Trying to predict what institutional investors and foreign governments are going to do is hard. But rates will almost surely go higher, potentially much higher, and could stay at elevated levels for years. It could take decades to rebuild the credibility of the US government.
Lower Spending Levels
Even if the Treasury is able to keep making interest payments, the cutting of funding to other programmes is going to have an impact on the economy and the recovery. The prospect of not paying Social Security, Medicare, contractors, and other government employees could mean a sharp contraction in government spending, not exactly the greatest thing for the recovery at the moment. Similarly, if the debt ceiling is raised but only on the condition of a sudden sharp contraction in spending, it will be somewhat of a Pyrrhic victory. We can look to the recent events in the United Kingdom to see how sharp budget cuts can have a deleterious effect on growth rates.
Even with severe cuts, it would be almost impossible to get the budget in balance without raising the debt ceiling. We've just committed to pay too much to too many people to pull back without issuing more bonds. Given that we will have to raise the ceiling regardless, getting that step out of the way now and hammering out the details of a more gradual reduction in spending after the pressure is off might soothe the pain. My fear is that a package put together hastily and agreed to at the last minute will be far from ideal.
Huge Lack of Confidence
One of the biggest X-factors is how scared investors will be if Congress fails to lift the debt ceiling. The enormous amount of uncertainty created by that event could look very similar to the enormous swings in stock market indexes we saw at the peak of the financial crisis. Open questions about how much businesses' costs of capital will rise, the stability of regulatory and taxation regimes, worries of a further-stumbling economy, and the quality of capital that banks hold could send shares much lower. The lack of confidence could easily spill over into the consumer mind-set, leading to a contraction in spending that would only compound the other problems.
What do you think? Will Congress lift the debt ceiling? What conditions will be attached? Where would investors move money if Treasuries were no longer seen as risk-free assets? Are you making any changes to your portfolio because of this uncertainty?
Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of markets editor Jeremy Glaser. Each week, Bearemy will share what's topping his list of concerns and invites you to reply or add your own in the comments section below.
