The writer is an FT contributing editor and global chief economist at Kroll
It’s Groundhog Day again for US debt limit silliness. But unlike the Bill Murray film, this is no comedy. The US faces a needless, self-inflicted financial mess that could drag on the global economy. This is lunacy. And investors must focus on it now.
Treasury secretary Janet Yellen is in the role of Punxsutawney Phil, the Pennsylvania groundhog whose shadow supposedly determines the length of winter. On January 19, she announced the US had hit its arbitrary debt ceiling, and that accounting legerdemain would allow the country to borrow for only six more months before defaulting.
So far financial markets have remained calm because a last-minute deal has always emerged to lift the debt ceiling. But default is now a much greater possibility. A small group of Republican hardliners have decided that the size of the national debt matters more than the full faith and credit of the government. The House of Representatives is so divided they may indeed take the country hostage.
The US Treasury market is the deepest, most liquid in the world. US sovereign securities are considered essentially risk-free. Lending around the world is based on spreads to Treasuries, which also influence currency values. A US default would roil global markets.
There is a market belief that if the US can no longer borrow, it will at least prioritise payments to bondholders over other obligations. Technically this should be possible, but both Treasury and the Federal Reserve have doubts 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 be paid, but rich foreign investors will be. The Biden administration insists this is not on the table, though its position may change as default draws nearer.
If it cannot borrow, plans developed by the Treasury in 2011 would have the government delay payments of other obligations until it had enough cash to cover a whole day’s bills. This would be recorded as “arrears” in the government books, something often seen in emerging markets. Even without a default on Treasuries, markets may decide failure to meet any payment obligation constitutes a default of some sort, triggering a global financial meltdown.
We know from the past that even brushing up against default is costly. The Government Accountability Office estimated the 2011 debt stand-off raised government borrowing costs by $1.3bn that year. In 2013, Fed economists estimated short-term government paper yields rose 21 basis points in 2011 and 46 basis points in 2013, and yields on other maturities by 4-8 basis points, costing the Treasury around $250mn in each episode.
If the debt ceiling were to bind, borrowing costs would rise much more, causing dislocations in markets with thin liquidity and necessitating Fed intervention. That’s another reason markets are relaxed for now. The Fed could temporarily restart quantitative easing and buy Treasuries, as the Bank of England did last September when UK government bond yields spiked. If a default pushed short-term rates up, the Fed could expand its standing repo facility. If demand for undefaulted government securities pushed 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 option chair Jay Powell called “loathsome” on a Fed conference call in 2013. Hoovering up defaulted securities would be met with lawsuits and could push up inflation when it is still too high. The Fed will also be wary of creating moral hazard by bailing out politicians dithering on lifting the debt ceiling.
Meanwhile, breaching the debt ceiling would depress government spending, as the Congressional Budget Office estimates that tax revenue meets only 80 per cent 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 when the economy is nearing recession.
The long-term implications of breaching the debt ceiling are the most pernicious. If investors worry they may not be paid what they are owed when they are owed it, they may demand a yield premium on Treasuries. Default could also prompt some countries to hedge their dollar bets by buying fewer Treasuries and adding other currencies to foreign exchange reserves.
Those politicians threatening default must drop their demands immediately. And markets should not delay in sending a message: their folly will lead to disaster.
