The oncoming October 17 U.S. debt ceiling continues to go unresolved. And the investing world is trying to make sense of it all. Business Insider recently had a Q&A with PIMCO’s Mohamed El-Erian about the matter. Here’s what he said.
What does the debt limit fiasco mean for the U.S. economy?
The last thing America’s still-sluggish recovery needs is a sinkhole of our politicians’ own making. Yet this is what it would get if Congress does not lift the debt ceiling in a timely manner.
While we think that, when push comes to shove, our politicians will come to their senses, we have analysed the possible consequences of a failure to do so. The bottom line is a simple one: cascading financial market dysfunction, an economy back in recession, higher unemployment, and greater global economic and financial instability.
What does it mean for the markets? Equities? U.S. Treasuries?
Here one has to differentiate very carefully the different stages of a possible, though unlikely, huge political debacle.
First there would be October 17th, the date that Treasury Secretary Lew specified when the U.S. would run out of legal debt issuance space. In the run up to that date, equity and other risk markets would likely get increasingly nervous.
In the event, October 17th would unlikely prove to be a hard deadline. Instead, between the cash on hand and some spending and revenue flexibility, the Treasury would probably be able to make it to the end of the month without incurring payments arrears.
Risk assets would likely come under greater pressure, reacting to every signal out of DC. Meanwhile, normal market functioning, including the important repo function, would be subject to growing strain and stress.
In the weeks that follow, the Treasury Department would be forced into a very delicate and challenging process of payment prioritization or delaying some payments outright. In either case, officials would probably seek to protect to the maximum extent possible the full faith and credit of the nation. As other spending commitments are cut very hard, equities would sell off significantly on concern of a major recession while Treasuries would likely out-perform.
If this process is drawn out — and, remember please, we believe that the probability of getting to this stage is very, very low — the U.S. could default on debt payments. While it would be doing so due to the lack of political willingness rather than financial ability, the result would be the same: The world would most likely be facing the likelihood of a great depression.
Fortunately, all this can, should and likely will be avoided when the minority in the Republican party realises that taking the debt ceiling hostage can have a catastrophic impact on current and future generations.
What does it do for America’s credibility to the rest of the world?
In addition to great economic damage at home, America’s standing in the global economy would be hard hit.
Countries would likely look to build an alternative (or alternatives) to the dollar-centric global financial system. This would undermine the substantial benefits and influence we derive from having the dollar serve as the world’s reserve currency, and from other countries out-sourcing a part of their financial intermediation process to what is the most sophisticated, deepest and, until recently, most predictable financial system.
Finally, and in addition to harming our economic interest, all this would undermine our global political standing and national security interests.
Could this be worse than the global financial crisis triggered by Lehman’s disorderly default 5 years ago?
Yes, much worse. And the sooner Congress realises this, the higher the probability that America would side-step a totally avoidable crisis of historic proportions.