(with Guntram Wolff)
On October 1st 2013, the US federal government officially entered a shutdown as no agreement was reached on the budget for 2014. Government shutdowns are nothing new in the US: There have been 17 such episodes since the late Seventies, the last of which occurred in 1995-96 under the Clinton administration. Based on these previous experiences, analysts and commentators tend to agree that the direct impact of the shutdown will be moderate, and the market reaction has been quite calm so far. The longer the shutdown lasts, however, the larger will be the consequences on GDP.
Government shutdowns are nothing new in the US: there have been 17 such episodes since the late Seventies
A much more significant threat comes from the US debt ceiling, for which an agreement in congress must be found by October 17th. The absence of a deal could – although it is not automatic that it would – trigger a default on parts of US debt obligations. Without a deal, analysts agree that scheduled auctions for October would probably have to be delayed or downsized to avoid hitting the ceiling. Towards the end of the month, however, the Treasury’s cash buffer would be exhausted, just ahead of significant payment obligations coming due on the 1st November (about USD 67bn in social security payments, healthcare programmes and military pay). For the US to technically default on its debt, the Treasury would need to miss payment of principal and/or interest on US securities, with significant uncertainty about whether and how this would happen. The outcome of this depends, to a large extent, on the possibility of resorting to “creative” solutions or to prioritise payments. Despite significant uncertainty, there seems to be consensus that the 15th of November could be the final countdown, with significant interest payments of USD 32 bn coming due on that date.
A scenario of technical default could be horrifying (e.g. see here for a summary), but markets have barely taken notice of the government shutdown thus far and are reacting with relative calm to the approaching debt ceiling deadline. A US default is the prototype of an ‘unthinkable event’, whose likelihood is by definition priced very low. In previous occasions of stalemate over the debt ceiling, including the last time in 2011, a very last-minute agreement has always been reached. It is also not the first time that a discussion on the debt ceiling comes along with a government shutdown – the same happened in 1995.
US default is the prototype of an ‘unthinkable event’, whose likelihood is by definition priced very low. But some factors could play differently this time
A number of factors could play differently into the equation this time around, with unexpected consequences. First, the politics is different. Several commentators have been pointing out that the hard-liner Republicans could turn out to be – for a number of internal reasons – far less malleable in 2013 than they were in 2011. Edward Luce, for instance, argued in the FT that the shutdown is ultimately a signal the Republican leadership is aware of being weaker than back two years ago, and looks to be legitimatised through an extreme show of strength. For this reason, their incentive to remain entrenched may be underestimated; the recent position taken by speaker Boehner suggests the same. Similarly, Ezra Klein points out that while there were some – although limited – points of contact between Democrats and Republicans in 2011, this seems impossible under present circumstances. Second, the global environment is different. When the downgrade happened in 2011, the US was still enjoying massive inflows from the global flight to safety, triggered by the collapse of Lehman in 2008 and then again by the Euro crisis in 2011. In the summer of 2011, Europe’s crisis reached a new low, affecting both Spain and Italy, making investors desperate enough to pay negative real yields on Bunds and Gilts. Under such circumstances, the US was considered something of a global safe haven. Risk appetite is still far below pre-crisis levels, but the situation in Europe has been improving since September 2012. Third, monetary policy was different. The FED was acting with full force and no discussion on tapering was yet on the horizon. It is interesting to note that during the 1995 government shutdown, the Fed eased an unexpected 25bn for the first time, following a series of rates hikes through 1994-95.
Meanwhile, on the other side of the Atlantic, Europe is left to wait and hope for the unthinkable not to happen. Europeans already had their taste of unthinkable at home, with the events in Cyprus, with little appetite for more. Although obviously of different type and magnitude, the situation in Cyprus was to some extent similar, considering markets’ psychology. Despite a rather long period of time with open talks of possible haircuts, deposits remained remarkably stable in the run up to the crisis. At least until the unthinkable eventually did happen, with the Eurogroup initially agreeing to impose a haircut on insured depositors, triggering a run that could only be stopped by means of another unthinkable – the imposition of capital controls in the monetary union. Even without venturing into the disastrous effects of a technical default on US debt obligations, the political uncertainty generated could boost inflows to the European market. A number of consequences could follow from this. First, the euro could appreciate, undermining the competitiveness of European companies, especially in the South, at a moment when euro area adjustment is still fragile. Second, capital inflows could be directed to Europe’s closest substitute to Treasuries, the Bund. This would be marginally beneficial for Germany, but also leave other member countries at a relative disadvantage.
Europeans already had a taste of unthinkable at home, with the events in Cyprus, with little appetite for more.
Dealing with unthinkable tail events is difficult, but the experience from Cyprus shows they can become reality. The uncertainty of having to imagine the unimaginable, might already have negative consequences for Europe. China urged the US political system to end its political impasse quickly – on which Europe should insist. End this highly dangerous game, before it risks shutting down the European economy along with its own.
This article was first published at Bruegel