It seems surreal that a Republican Presidential contender can say she will oppose raising the permitted debt ceiling when it will be reached within a week and the approved Federal budget is in deficit to the tune of some 9% of GDP this year – $25bn per week.
Lack of credibility
It is barely credible that the world’s largest creditor with a hitherto AAA-credit rating is at risk of voluntarily closing down its government or defaulting on interest payments because the two parties cannot agree on a mix of spending cuts and tax increases to begin to restore the US budget finances.
Politics may be a game when it is posturing for electoral advantage over issues which are unimportant but statesmanship is meant to kick in when the issues are so important that the public interest trumps narrow party advantage.
The implication of not raising the debt ceiling to accommodate a legally approved budget is that any spending in excess of day-to-day tax revenues raised will stop. Ways that this could be implemented include stopping the pay of public servants, politicians or the army, cutting back government purchases or failing to meet interest payments. The amount of public spending to be cut for the government to operate in surplus are not trivial – over $1,000bn, or one-third of the annual budgeted spending.
Such a dramatic fiscal tightening (an annualised 9% of GDP overnight) would immediately plunge the US, and no doubt most of the world, economy into recession. If there were a failure to make interest payments on US Treasury bonds, which are viewed as the risk-free foundation to the markets’ entire pricing structure for riskier assets, the implications for financial markets would also be extremely severe.
Get on with it
It is because the implications are so severe that it is puzzling why politicians do not as a matter of course raise the debt limit then get on with the debate over how to narrow the deficit in future.
The severe consequences of the path being pursued undermine the belief that it could happen.
Unfortunately, the US may be solvent but its politics are not sober. A misjudged game of chicken could lead to a car crash, even if the severe market and political consequences rapidly forced a reversal. This is what is enabling financial markets to view the possible calamity calmly. Everyone believes a deal will be done to avert a default and government shutdown. Hence bond yields are low and equities range-bound. People want to be invested for a post-deal bounce. Yet without some market volatility those in Congress who have an Alice in Wonderland view of the world will not see sense.
It seems likely that, through some tortuous process in coming weeks, the US will raise its debt ceiling and take limited steps towards reducing its budget deficit. Provided that the preceding shenanigans has not unduly damaged economic confidence, this would allow equity markets to shift attention to the prospects for earnings and shed their anxiety about recent macroeconomic events.
Short-term binary events are less important for investors than for traders but the ignorant nature of the US fiscal debate means one cannot totally rule out someone pressing the auto-destruct button.
