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If Congress fails to lift the limit on America s debts, the consequences are
uncertain but definitely unpleasant
WHEN big chunks of America s federal government suspended business on October
1st markets mostly yawned. Although the shutdown was the first in 17 years,
the political dysfunction that caused it has become the norm in Washington, and
the economic consequences are slight. Nerves are now beginning to fray,
however, because something far worse looms. On October 17th the Treasury will
run out of ways to sidestep the limit Congress places on the federal government
s debt and so will no longer be able to borrow.
As a result it could, within weeks, be unable to pay some bills. Whether this
would mean defaulting on its bonds, and thus throwing financial markets into
chaos, is unclear. But the prospect is causing jitters. It is becoming more
expensive to insure against an American default using credit-default swaps (see
chart). Meanwhile, the Chinese government, among others, has urged America not
to let its partisan paralysis infect the world economy.
The fear is that amid the political brinkmanship, the Treasury will miss an
interest payment on some of its debt, in spite of the fact that America is
perfectly solvent and should have no trouble paying its bills. That would play
havoc with the global financial system, which depends heavily on American
government bonds as a common, liquid and hitherto safe asset. Over $500
billion-worth change hands every day. They constitute a big share of the
collateral that banks around the world put up to secure short-term funding. If
America defaults, lenders may refuse Treasuries as collateral because they
could not be sure that anyone else would accept them, says Michael Cloherty of
RBC Capital Markets. That could trigger a cash crunch and a spike in demand for
alternative collateral. Financial institutions might start hoarding funds,
causing markets to seize up.
For now, such a calamity is not the likeliest outcome. Both sides want to raise
the debt limit before the deadline, perhaps as part of a deal that ends the
shutdown as well. One possibility is that Congress raises it by a small amount
to allow further negotiation over the budget and health-care reforms.
In the meantime, the shutdown is doing little damage. For one thing, it applies
only to the third of federal spending that Congress has to reauthorise each
year. The rest, including interest payments on America s debts and outlays on
Social Security (government pensions), Medicare (health care for the old) and
most government assistance for the poor, carries on as usual. In addition,
functions that fall within the affected third but are deemed essential, such as
defence, air-traffic control and disaster assistance, not to mention Congress
and the White House, are exempt.
Economists initially reckoned each week of the shutdown would trim 0.1 to 0.2
percentage points off America s annualised growth rate in the fourth quarter,
thanks chiefly to the forgone pay of roughly 800,000 idled federal employees.
However, estimates of the damage done have dropped by as much as half since the
Department of Defence recalled most of the 400,000 employees it had put on
leave without pay and the House of Representatives voted to make good the
losses of other civil servants.
Those pay-cheques will be in jeopardy again if the debt ceiling is not raised.
Increases used to be routine: after all, Congress regularly approves budgets
that include deficits and thus, arithmetically, lead to a higher national debt.
But if Congress remains obdurate, the federal government will have to renege on
some obligations. The Treasury hit the current ceiling of $16.7 trillion on May
19th and has since used book-keeping manoeuvres to keep issuing debt and paying
bills. On October 17th, it says, it will have exhausted those tactics.
It will still have $30 billion of cash on hand, and will continue to collect
taxes. But it will soon struggle to make several large payments: $12 billion
for Social Security on October 23rd, $6 billion in interest on the debt on
October 31st and $67 billion in payments for Social Security, Medicare and
bureaucrats and soldiers salaries on November 1st. By that date, analysts
reckon, the Treasury will miss a payment on something.
But it may not be on the debt. Many analysts, including Moody s, a
credit-rating agency, believe that the Treasury will ensure that interest is
paid before other obligations. The Treasury has suggested it does not have the
technical ability or legal authority to prioritise one payment over another. It
would be awkward, naturally, for politicians to argue that old, poor and sick
Americans should forgo their government benefits so that foreign bankers and
governments can continue to earn interest on their huge holdings of Treasuries.
Picking among the many deserving Americans owed money by the government would
be almost as hard.
Even if America does pay the interest on its debts, the economy would not be
saved. To eliminate its deficit instantly the federal government would have to
slash spending by 4% of GDP, assuming interest payments are made, according to
JP Morgan Chase, a bank. If sustained, that would be enough to bring on a
recession. Unlike with a shutdown, nothing would be spared: pensions, health
care and military salaries would all be vulnerable.
If by choice or miscalculation the Treasury does miss an interest payment, it
might not suffer as much as the rest of the financial system, in the short run.
In theory, a default should cause the price of Treasuries to plunge and
interest rates on new issuance (if and when it resumes) to soar. However, if
default triggered panicked sales of stocks and other assets normally seen as
riskier, the result might in fact be a rush into Treasuries. There are no
cross-default provisions on Treasuries, which means that missing a payment on
one does not automatically place the others in default. This, combined with the
lack of ready alternatives, may deter banks, mutual funds, and sovereign-wealth
funds from mass selling.
Nonetheless, a default would do lasting damage to the government s finances.
What sets Treasuries apart is the fact that holders can turn them into cash at
a moment s notice either by selling or pledging them, notes Wrightson ICAP, a
broker. Once Congress establishes the precedent that debt-service payments can
be delayed on a political whim, Treasury securities will no longer be immune
from liquidity risk. America would have jeopardised the exorbitant privilege
, as a French minister once put it, of borrowing in the world s most trusted
currency.