TOL - 2nd Feb, 2023
The nuclear bomb that would change the face of modern finance (and your portfolio), if it goes off
The US just passed its debt limit. If that limit isn't raised, the global economy could go into free-fall.
As with nuclear weapons, US default has been subject to a kind of “norm of non-use.”
But also like nuclear weapons, a single incident of US default is all it would take for the world as we know it to change.
“It’s overly necessary for Congress to raise the debt limit, and I hope they do so in a timely way before we come to a crisis,” US Treasury Secretary Janet Yellen said in a Bloomberg interview earlier this month.
“I think we feel strongly it will be a calamity not to raise the debt ceiling.”
I recently had the opportunity to sit down with Dr John Kunkel, Senior Economics Adviser at the United States Studies Centre at the University of Sydney. Most recently, he was the Chief of Staff to former Prime Minister Scott Morrison.
Drawing on that chat, this wire will explain default, its likelihood, how it can be avoided, and what a default would mean for the international financial system.
Defaults and ceilings
The US government spends more money than it pulls in through tax and other sources of revenue. To fund this gap, the US government sells debt via Treasury bills.
The “debt ceiling” (also called a debt limit) is the total amount of money that the United States government is legislatively authorised to borrow to meet its financial obligations. It’s essentially a line of debt for Congress.
Default occurs when the government's financial obligations eclipse tax revenue, other revenue and treasury debt.
The US has defaulted four times – in 1862, 1933, 1968, and 1971. While it’s come close to defaulting several times since, Congress has been able to raise the debt ceiling.
Currently, the debt ceiling is US$31.4 trillion.
The US pushed through that ceiling earlier this month.
Extraordinary times call for extraordinary measures
But wait. If the debt limit has been breached, why no default?
Passing the debt ceiling doesn’t lead to instant default. The US Treasury has “extraordinary measures” at its disposal to buy time.
In a letter to House Speaker Kevin McCarthy, Yellen said the Treasury would stave off default by postponing new investments in the Civil Service Retirement and Disability Fund and the Postal Service Retiree Health Benefits Fund.
But this is a short-term solution. If Congress doesn’t raise the debt ceiling, the US will eventually default on its debt.
“The period of time that extraordinary measures may last is subject to considerable uncertainty, including the challenges of forecasting payments,” said Yellen. "I respectfully urge Congress to act promptly to protect the full faith and credit of the United States.”
Game of chicken
Failing to raise the debt ceiling to avoid default is a political problem with financial costs.
Kunkel believes the likelihood of default is low but not negligible.
"I think in some quarters, the new Republican Congress has a tilt towards brinkmanship this time. Add to that the fragility of the global economy and I don't think you can be entirely relaxed about the situation at all," he said.
In August last year, then GOP House minority leader Kevin McCarthy stated openly that if Republicans won a majority (which they ultimately did), they would use the debt ceiling as leverage to cut the federal budget.
“If people want to make a debt ceiling [for a longer period of time], just like anything else, there comes a point in time where, okay, we’ll provide you more money, but you got to change your current behaviour,” he said.
“We’re not just going to keep lifting your credit card limit."
This brinkmanship has been variously characterised through game theory as a prisoner's dilemma, but Kunkel believes it's more like a game of chicken.
"Prisoner's dilemma tends to be where both sides are incentivised to take a strategy and both sides ultimately lose, whereas I think this is very much sort of raw politics where it all comes down to who blinks," he explained.
"In terms of the Republicans, they want to force the President to make spending cuts, whereas the Democrats want to hang any sort of economic chaos - and ultimately particularly any battle around entitlement spending, for example - around the neck of the Republicans. It's a sort of a zero-sum political game."
Financial bomb
If the US (on the back of which the global financial system is built) were to default, the financial costs would be enormous.
"In the near term, rates would go up very high, and that would hit consumer and business confidence," Kunkel said, who added that a default could lead to a 10% fall in economic activity.
Goldman Sachs was even blunter in its warnings.
"If there were any doubt about the US government’s ability to make interest and principal payments on time, that could have very, very adverse consequences,” Goldman Sachs Chief Economist Jan Hatzius told CNN last week."You get turmoil in financial markets, a big tightening in financial conditions and that adds to downward pressure on economic activity."
In 2011, S&P cut the long-term US rating by one notch to AA+ following on the back of a week-long stalemate over the debt ceiling, and that was without a default.
Then there's the longer-term damage to US credibility.
"It starts predominantly with the US dollar as a reserve currency and the lynchpin of the global economy and the US financial system," Kunkel said.
Fiscal repair
The debt issue is fundamentally a fiscal problem. The US debt to GDP ratio is currently 133%. Until that ratio is brought down, the spectre of default will continue to rear its ugly head.
But it's a fiscal problem that's mediated through a Congressional house with the slimmest of majorities.
"At the end of the day, you can make out that it's easy to cut spending, but the reality is it's always politically very, very hard," Kunkel said.
Here's hoping that common sense prevails. As Winston Churchill famously said, “Americans will always do the right thing, but only after they have tried everything else."
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David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.
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David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.
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David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.
Expertise
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