Photo: Pete Souza via Wikimedia
In terms of disinterested analysis of the debt ceiling situation, this article on Morgan Stanley’s Global Economic Forum (via Self-Evident) may be as good as you’re going to get.We’ll run through the key points.
First, the Treasury has various accounting gimmicks to get around a hit of the debt ceiling:
Absent any special action by the Treasury, we believe that the debt ceiling would first begin to pose problems in late March. However, the initial step to address the problem is relatively straightforward. Beginning in early March, we believe that the Treasury will start to wind down the Supplementary Financing Program (SFP). This will free up $200 billion in borrowing capacity. But, it could also have a meaningful impact on the bill sector, with spillover to the rest of the money markets, since the SFP represents about 10% of the outstanding supply of bills at present. Around the same time, the Treasury is also likely to suspend SLGS issuance. Once these steps are taken, and with the benefit of April tax inflows, the Treasury will likely remain under the limit until late May. At that point, more drastic action would be necessary.
The most powerful tool that the Treasury has to manoeuvre around the debt ceiling is to suspend reinvestment of certain government trust funds (note: this is often referred to as “disinvesting” the trust funds). Such action must be preceded by announcement of a “debt issuance suspension period”. This is an accounting gimmick that has been used in the past to free up some borrowing authority (for more details, see the GAO reports, Debt Ceiling: Analysis of Actions Taken During the 2003 Debt Suspension Period and Debt Ceiling: Analysis of Actions During the 1995-1996 Crisis).
Of course, eventually the Treasury could run out of gimmicks, and the possibility of default is non-trivial (PS: This is why we keep saying the US doesn’t deserve its AAA status!).
What’s interesting is that there will likely be a claque of politicians and outsiders who will be “pro-default” just like there were the last time this became an issue, during the government shutdown of 1995.
If Congress refuses to enact even a temporary extension, then the Treasury will eventually run out of accounting gimmicks and will be unable to legally meet the government’s obligations. Obviously, this scenario has an extremely low probability, but it is non-zero. In fact, during the 1995-96 episode, a number of key players even argued that it would be less damaging to the economy and the financial system for the Treasury to default than it would be for the Republicans to back away from the pledge to achieve a balanced budget. In addition to the aforementioned speech by House Speaker Gingrich, commentator James Glassman authored an op-ed in the Washington that said default was not as bad as “Wall Streeters” say it is. And, two well-known money managers took out a full-page ad in the Washington Post that said: “Let’s not allow fears of temporary market instability serve as an excuse for equivocating on spending cuts”.
Some history here: They were freaking out about the deficit in 1995 and it’s 16 years later, and our borrowing costs are cheaper than ever.
This is probably the most interesting part: What happened in financial markets this time it became an issue?
In addition to the direct impact on the Treasury bill market associated with a winding down of the SFP, a debt ceiling showdown could rattle investor confidence. It’s always a bit difficult to isolate the market impact of factors such as this that tend to play out over a lengthy period of time, because so much else is going on at the same time. But there is some evidence to suggest that there was a noticeable spillover effect on bond and currency markets during the 1995-96 experience. For example, in the lead-up to the 1995-96 episode, House Speaker Gingrich delivered a speech in which he warned that he was prepared to default on the debt unless the president agreed to Republican demands. “I don’t care what the price is”, Gingrich said. Here is a Washington Post report from September 21, 1995 that (partially) attributed a significant move in the dollar and a rise in Treasury bond yields to that threat:
“House Speaker Newt Gingrich threatened today to send the United States into default on its debt for the first time in the nation’s history, to force the Clinton Administration to balance the budget on Republican terms. His comments, a more extreme version of the hardball stance frequently used in past budget showdowns, raised the specter that the looming stand-off may begin to rattle financial markets around the world. Mr. Gingrich’s remarks came in the middle of a day in which the dollar plunged as much as 5 per cent against major currencies before recovering slightly, sending interest rates up sharply. The Speaker’s statement appeared to be one of several factors that added to the markets’ unsettled condition. More broadly, Mr. Gingrich’s speech to the Public Securities Association, which represents traders in government debt, underscored the growing agitation and sense of imminent collision in official Washington as both Democrats and Republicans move toward a confrontation that could shut the government down this fall.”
That, folks, is what a sovereign debt freakout would look like in the US. When yields are spiking and the dollar is falling, that means people are worried about getting paid back on their debt. What we’ve seen lately — rising yields and the rising dollar — is healthy and not associated with debt concerns at all.
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