Hitting the Roof

If Congress fails to lift the limit on America’s debts, the consequences are uncertain but definitely unpleasant.

When big chunks of America’s federal government suspended business on October 1 markets mostly yawned. Although the “shutdown” was the first in 17 years, the political dysfunction that caused it has become the norm in Washington, and the economic consequences are slight. Nerves are now beginning to fray, however, because something far worse looms. On October 17 the Treasury will run out of ways to sidestep the limit Congress places on the federal government’s debt and so will no longer be able to borrow.

As a result it could, within weeks, be unable to pay some bills. Whether this would mean defaulting on its bonds, and thus throwing financial markets into chaos, is unclear. But the prospect is causing jitters. It is becoming more expensive to insure against an American default using credit-default swaps (see chart below). Meanwhile, the Chinese government, among others, has urged America not to let its partisan paralysis infect the world economy.

The fear is that amid the political brinkmanship, the Treasury will miss an interest payment on some of its debt, in spite of the fact that America is perfectly solvent and should have no trouble paying its bills. That would play havoc with the global financial system, which depends heavily on U.S. government bonds as a common, liquid and — hitherto — safe asset. Over $500 billion-worth change hands every day. They constitute a big share of the collateral that banks around the world put up to secure short-term funding. If America defaults, lenders may refuse Treasuries as collateral because they could not be sure that anyone else would accept them, says Michael Cloherty of RBC Capital Markets. That could trigger a cash crunch and a spike in demand for alternative collateral. Financial institutions might start hoarding funds, causing markets to seize up.

For now, such a calamity is not the likeliest outcome. Both sides want to raise the debt limit before the deadline, perhaps as part of a deal that ends the shutdown as well. One possibility is that Congress raises it by a small amount to allow further negotiation over the budget and health-care reforms.

Prices of U.S. CDSIn the meantime, the shutdown is doing little damage. For one thing, it applies only to the third of federal spending that Congress has to reauthorize each year. The rest, including interest payments on America’s debts and outlays on Social Security (government pensions),  Medicare (health care for the old) and most government assistance for the poor, carries on as usual. In addition, functions that fall within the affected third but are deemed essential, such as defense, air-traffic control and disaster assistance, not to mention Congress and the White House, are exempt.

Economists initially reckoned each week of the shutdown would trim 0.1 to 0.2 percentage points off America’s annualized growth rate in the fourth quarter, thanks chiefly to the forgone pay of roughly 800,000 idled federal employees. However, estimates of the damage done have dropped by as much as half since the Department of Defense recalled most of the 400,000 employees it had put on leave without pay and the House of Representatives voted to make good the losses of other civil servants.

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