TH woke up this morning with that catchy tune “the ceiling can’t hold us” and thought how apt it is to describe the behaviour of the US congress, which may soon recklessly drive the global economy into yet another financial crisis by choosing not to lift the US debt ceiling before October 17 (D-Day). It also got TH thinking about what would actually happen if no agreement is reached and congress actually failed to act, and how we might end up in that situation.
To think through, it is helpful to imagine what would happen if nothing else happened except that the debt ceiling is reached and the government loses the ability to issue new debt. First, the US government shutdown, which is underway at present, would have to sharply accelerate to constrain expenditures to avoid new borrowing. The sharp acceleration will have all sorts of macro consequences, the most notable of which would be a sudden contraction in US GDP growth and loss of jobs. The more interesting and worrisome complication is that because certain expenditures can’t just be constrained or stopped, the US government will probably have to default on some liabilities.
Sovereign default is never good; especially for people who are holding the debt that the government defaults on.
So imagine that there you are on October the 16th (the date when congress votes (or doesn’t vote) to raise the debt ceiling. And as the votes come in, it becomes clear that you are holding debt that is due to be redeemed in the next few days and will therefore most likely be defaulted on. You are holding the hot potato. Of course you try and sell it, as does everyone else. The price of the debt plummets; you wished you had sold the day before. Of course in reality, many people wouldn`t have been as optimistic as you, and would have sold the day or week before. There will be a point where bond selling along with the various uncertainties will cause markets to start behaving badly. Something a kin to a run starts. Liquidity dries up, short-term interest rates spike, banks stop making loans, and so on. You know the drill. Something like what happened when Lehman Brothers was forced to default. It would be nothing short of a financial and economic calamity that could make the Lehman Brothers moment look good.
But that scenario assumes nothing else happens. And of course something will. The US Federal Reserve will have its “whatever-it-takes” moment and intervene to avoid disaster. The simplest way would be for it to stand ready to buy any US Federal government debt, including (and most importantly) the debt that the government is about to default on. It would effectively take on the debts for the US treasury even the debt on which the government is in arrears on. This would effectively amount to a new (fourth) round of quantitative easing – QE4
Some will no doubt worry that this will be inflationary. It need not be. The US Fed does not only have to issue money in exchange for those dodgy US Treasuries. It can issue its own bonds instead. In practice it would probably to a bit of both. The problem is that this will affect the well-being of the financial system in general, raising the overall costs stemming from the excessive reliance on monetary policy. But for now, calamity avoided.
Phew, so now you breathe a sigh a relief. You don’t need to panic now. You can just wait until D-Day and for the Federal Reserve to come to the rescue. The trouble is that you are not the only ones that can do the calculus. The members of the US congress can too. The fact that the situation has gone this far shows that congress is already willing to overburden the US Fed. The question is how much further they are willing – how much larger are the nips of liquidity going to get?
As the famous Mental As Anything song goes:
Started out, just drinkin’ beer
I didn’t know how or why
Or what I was doin’ there
Just a couple more
Made me feel a little better
Believe me when I tell you
It was nothin’ to do with the letter
I ran right out of beer
I took a look into the larder
No bones, nothin’
I’d better go and get somethin’ harder
Back in a flash
I started on a dash of Jamaica rum
Me and Pat Malone
Drinking on our ow-ow-ow-own
Woh-hoh-oh, the nips are gettin’ bigger
Woh-yeah, the nips are gettin’ bigger
Wo-hoh-oh, the nips are gettin’ bigger
Yeah-eah-eah, mmm they’re gettin’ bigger