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comment analysis

today • tuesday 8 october 2013

Five reasons to fear a US default
BloomBerg editors

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o keep spending, the United States government needs Congress to pass a spending law. Republicans have already blocked this, resulting in a partial government shutdown. Now, they are threatening the separate and much more disruptive step of refusing to raise the federal debt ceiling, currently set at US$16.7 trillion (S$20.8 trillion). Spending exceeds revenue, so without permission to borrow more, the government can’t pay its bills even if a law to allow spending goes through. If the debt ceiling stays in place, the Treasury will run short of cash soon after Oct 17. At that point: 1. Global markets will see the US government as grossly and dangerously incompetent. Refusing to raise the debt ceiling is fundamentally different from cutting the government’s funding. It’s as if Congress were sending the Treasury two contradictory and legally binding orders — one that requires it to make hundreds of billions of dollars a month in payments, another that prevents it from borrowing the money it needs to do so. Which order is the Treasury supposed to obey? This is the stuff of absurdist theatre. Confidence matters and this event would destroy confidence. 2. Forced spending cuts will kill the economic recovery. Over the course of a year, the Treasury borrows roughly US$1 out of every US$5 it spends, so hitting the debt ceiling would require it to cut outlays by about a fifth — and by much more in the short term, because flows into and out of the Treasury are lumpy. Such a severe fiscal squeeze would crush a still-tentative recovery at a time when widespread unemployment is threatening to do permanent damage to the country’s productive capacity. 3. The US government might actually default on its debts. Some in Congress apparently think that hitting the debt ceiling needn’t mean missing a payment on the US$12 trillion in government bonds outstanding — an event that markets would call a default, which could trigger a financial catastrophe (see point No 4). The House of Representatives has passed legislation to authorise the Treasury to prioritise such payments. Even if the Senate passed that measure, which it has refused to do so far, it might not be enough. The Treas-

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ury processes more than 80 million separate payments a month, using an elderly system that wasn’t designed for debt-ceiling damage control. Money to bondholders goes through a separate channel called Fedwire, so some segregation might be possible — but accidents are all too probable and a payment could easily go missing. Markets are aware of the risk: Yields of Treasury bills maturing in the second part of this month are abnormally high, suggesting that investors are demanding compensation. The cost of insuring against a US default has almost doubled. 4. A default could trigger a global crash. Treasury bonds are the foundation of the US and global financial systems. Their yields serve as benchmarks for interest rates on mortgages and corporate bonds. Securities dealers in the US hold some US$1.9 trillion in Treasuries as collateral on loans to hedge funds, banks and other financial companies. Mutual funds, pension plans and corporations rely on interest payments from Treasuries to meet their obligations to investors, retirees and workers. The slightest concern about the US government’s ability or willingness to pay could prompt investors to demand a higher return on the bonds and dealers to toughen the terms on which they accept Treasuries as collateral. That would abruptly raise the cost of credit for everyone — or else freeze financial markets altogether. Economists have estimated that a few missed Treasury-bond payments in 1979, the result of a brief technical glitch, pushed up interest rates by 0.6 percentage point and boosted the US government’s borrowing costs by US$12 billion a year. It’s hard to overstate the danger. Picture a crisis in which markets froze and the US government was unable to act because its own creditworthiness was the cause of the panic.

5. The government’s fiscal problems will only get worse. It’s true that US finances are on a troubling long-term trajectory: The government has promised more to future retirees than taxpayers seem willing to pay. But in the current impasse, this issue is barely on the table. Meanwhile, heightened fears among investors will increase the government’s cost of borrowing. Even a rise of 1 percentage point would increase the government’s costs by US$120 billion a year. BLOOMBERG