The author is editor of FT and chief global economist at Kroll
It’s Groundhog Day again for the stupidity of US debt limits. But unlike Bill Murray’s film, it’s not a comedy. The United States faces an unnecessary, self-inflicted financial mess that could weigh on the global economy. This is madness. And investors need to focus on that now.
Treasury Secretary Janet Yellen stars as Punxsutawney Phil, the Pennsylvania groundhog whose shadow is believed to determine the length of winter. On January 19, she announced that the United States had reached its arbitrary debt ceiling and that the accounting sleight of hand would allow the country to borrow for just six months before defaulting.
So far, financial markets have remained calm as a last-minute deal has always emerged to lift the debt ceiling. But failure is now a much bigger possibility. A small group of Republican hardliners decided that the size of the national debt mattered more than the full confidence and credit of the government. The House of Representatives is so divided that it could well hold the country hostage.
The US Treasury market is the deepest and most liquid in the world. US sovereign securities are considered essentially risk free. Lending around the world is based on spreads over treasury bills, which also influence currency values. A US default would disrupt global markets.
The market believes that if the United States can no longer borrow, it will at least prioritize payments to bondholders over other bonds. Technically, this should be possible, but the Treasury and the Federal Reserve doubt that it can be implemented. There would be a slew of lawsuits and the optics are politically toxic. Imagine President Joe Biden telling Americans that firefighters and soldiers won’t get paid, but wealthy foreign investors will. The Biden administration insists that’s not on the table, though its position may change as default nears.
If it cannot borrow, plans drawn up by the Treasury in 2011 would force the government to delay paying other obligations until it has enough cash to cover an entire day’s bills. This would be recorded as “arrears” on the government books, which is often seen in emerging markets. Even without treasury bond defaults, markets may decide that failure to meet any payment obligation constitutes some kind of default, triggering a global financial meltdown.
We know from the past that even getting rid of a default is expensive. The Government Accountability Office estimated that the 2011 debt impasse increased government borrowing costs by $1.3 billion that year. In 2013, Fed economists estimated that yields on short-term government paper increased by 21 basis points in 2011 and 46 basis points in 2013, and yields on other maturities by 4 to 8 basis points. base, costing the Treasury around $250 million each episode.
If the debt ceiling were to tighten, borrowing costs would rise much more, causing disruption in low-liquidity markets and requiring Fed intervention. This is another reason why the markets are relaxed at the moment. The Fed could temporarily reinitiate quantitative easing and buy Treasuries, as the Bank of England did last September when UK government bond yields soared. If a default drives up short-term rates, the Fed could expand its standing repo facility. If demand for non-defaulted government securities pushes their yields too low, the Fed could lend Treasuries to the market via reverse repos.
The central bank could accept defaulted Treasuries as collateral or buy them, an options chairman Jay Powell called “disgusting” on a 2013 Fed conference call. lawsuits and could push inflation up when it is still too high. The Fed will also be careful not to create moral hazard by bailing out politicians who are reluctant to lift the debt ceiling.
Meanwhile, exceeding the debt ceiling would reduce government spending, as the Congressional Budget Office estimates tax revenue covers only 80% of US spending needs beyond interest payments. Without government payments, some households and businesses would be unable to pay their bills, a drag on growth just as the economy approaches recession.
The long-term implications of breaching the debt ceiling are the most pernicious. If investors fear that they will not be paid what is owed to them when they are, they can demand a performance premium on the Treasury bills. A default could also prompt some countries to hedge their bets on the dollar by buying fewer Treasuries and adding other currencies to foreign exchange reserves.
Politicians who threaten to default should immediately drop their demands. And the markets should soon send a message: their folly will lead to disaster.