Opinions - 18.10.2012 - 00:00
29 Juli 2011. What had been a formality in the past has now mushroomed into a major political dispute between and, more importantly within, the U.S. political parties. Some market participants note that the TARP programme wasn't passed by the U.S. Congress until there was sharp correction in U.S. financial markets, these analysts wonder whether the trigger for legislative action will be another walk close to the financial abyss.
Ultimately, what matters is that confidence in a benign, if last minute, decision to raise the debt ceiling has been undermined. Consequently, the cost of insuring US Federal debt against default has increased sharply and the recent falls in the U.S. dollar suggest that some investors are taking steps to limit their exposure to dollar-denominated assets. Now that the financial markets are recalibrating their expectations, should you?
Here it is important to remember that, for all the political smoke and mirrors, what really matters is whether the U.S. government will default on its obligations. There are no indications that the U.S. government is having any difficulty selling debt on financial markets, even with the current massive Federal budget deficit.
No other financial assets are as readily traded as U.S. government debt. Moreover, those countries with massive trade surpluses have to buy some foreign assets on a regular basis. At the moment it is estimated that China alone has to acquire the equivalent of USD 200 billion every three months. Short of a major shift in those surplus governments' investment allocation decisions, there will be plenty of takers for U.S. Federal debt.
The game changer is the legal authorisation to raise the total level of outstanding U.S. Federal debt. Without such authorisation, which Congress must approve, then the U.S. Treasury can't issue any more bonds, no matter what the demand is for them. At some point in the relatively near term failure to extend the "debt ceiling" will cause the U.S. to default on the repayment of outstanding debts or not pay certain other obligations, like salaries and pensions. Both outcomes are grim: the former will trigger an upward shift in interest rates as the markets demand a default premium on lending to the U.S. government, the latter will probably tip the U.S. back into recession.
As we approach the 2 August 2011 deadline for legislative action, these factors will dwell more on the minds of financial markets and a sharp several hundred points fall on Wall Street cannot be ruled out. Nor can further falls in the value of the U.S. dollar and banks and insurance companies hoarding cash. These sharp financial adjustments would provide the trigger for Congressional action, but what matters is how much the debt ceiling is increased.
While there has been a lot of talk about linking any legislation on the debt ceiling with tax increases and spending cuts, ultimately the latter two are of secondary importance in the near term. After all, any such promises can be reversed through future legislative action and there is no way to bind a future U.S. Congress to any deal struck today. In a perverse way the very fact that U.S. politicians appreciate this may make it easier to legislate an increase in the debt ceiling now: the Democrats will discount the announced spending cuts, the Republicans will doubt that any announced tax increases will never be implemented. Indeed once the politicians figure this out, the promised fiscal retrenchment will become vaguer--the ratings agency be damned! The financial markets won't mind that much either: once the debt ceiling is raised, talk of a future U.S. Federal default is just another "maybe."
Another consequence of a rude financial shock in the next week or so would be to persuade U.S. politicians that they don't want to go through this ordeal again anytime soon. So expect a debt ceiling increase that--given the current projections for the U.S. Federal deficit--ensure that this matter does not arise before the next U.S. presidential election. A two trillion dollar plus increase, then, in the Federal debt ceiling can be expected.
Over the longer term the U.S. government will have to face its parlous fiscal situation but that will be a matter for another day. Without a trigger--such as running up against the Federal debt ceiling--financial markets are likely to discount concerns about U.S. solvency so long as plenty of buyers of U.S. Federal debt present themselves.
From being the principal casualty of a failure to lift the U.S. Federal debt ceiling the financial markets are likely to become the trigger for the resolution of this current Washington drama. Keep an eye on what is agreed about the debt ceiling, the rest of the package is presentational garnish.
(Simon J. Evenett is Professor of International Trade and Economic Development and Academic Director of the MBA Programme, University of St. Gallen, Switzerland.)
Copyright: photocase.com / Sonnabendkot
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