The US government shutdown, currency sovereignty and sovereign default
Summary: As the US government shutdown continues, the risk of default grows. Below are some thoughts on why this has played out as it has and what the outcome may be.
I have not written a lot about the government shutdown because it veers into the political and outcomes are more uncertain in highly politicized economic events. The only post I have written since the shutdown was exactly a week ago entitled “On the US government shutdown“. This is a members-only post, though. For members and non-members alike, I do have more thoughts on the shutdown and I am putting this outside the paywall.
First, because I have lived in and around Washington D.C. for a very long time, I have a lot of contacts in government and politics. So, despite my protests about hating politics, the reality is I am pretty close to the picture. The overarching view I have been getting from the outset as I wrote late in August is that a debt ceiling showdown was inevitable. The shutdown over Obamacare is a ‘bonus’ tacked on for the same reasons that the debt ceiling crisis was inevitable – a stark contrast between parties on government’s role concerning American fiscal and social issues.
When I wrote about the standoff last week, I made two historical references. One was to the Suez Crisis in the UK in 1956, which is now seen as the historical point of the U.K.’s decline out of geostrategic military power. Will this be a similar event in hindsight? Perhaps. Other countries are certainly aghast at the spectacle.
The second reference I made was to the U.S. Civil War (between the States). I wrote that you really had to go back to the Civil War to see division this stark in the United States. “If you go back to previous US government shutdowns in the late 1970s or the early 1980s or during the Clinton administration, there was rancour but there was no threat of debt default. And I believe this is significant. For me it signifies a level of partisanship, dysfunction and ideology that is extremely dangerous – and not just for the US but for the world’s economy because of the importance of the US as an actor on the world stage.”
In sum, I believe this is a very big deal historically.
From a tactical perspective, it makes sense for some Tea Party Republicans to push these issues because they have to get elected every two years in districts which are ideologically behind the fight against government interventionism, Obamacare, taxation and fiscal deficits. These members of Congress fear, if anything, that they will be attacked and defeated by opponents more ideologically-driven on those issues. And so, out of a sense of pure political survival, it makes sense for them to champion these issues. And this is why I expected this fight and continue to expect more fights like these.
From a party perspective, this fight is ruinous for Republicans in my view. It is clear that people like John Boehner and Mitch McConnell are not behind these fights. The word here is that Boehner is ready to compromise and that McConnell laid into Ted Cruz over his leading the anti-Obamacare campaign with his Senate filibuster. Boehner and McConnell are concerned about what Bruce Bartlett, a former Reagan political appointee and Republican congressman staffer, wrote about on Friday, that this government shutdown will defeat the GOP in 2014. Here is what Bartlett wrote that makes sense for me:
“…what we are seeing today is an exceptionally rare event in the history of government funding…
One really has to go back to the Civil War era to find a time when one party was as disdainful of democracy as Republicans are today. Then it was the Democrats, who represented the slaveholding South and thought any means were justified to defend the principle of slavery.
Abraham Lincoln, the first Republican president, explained in his first inaugural address that if a minority persists on forcing the majority to accept its demands, and is willing to use any means necessary to do so, then the inevitable result will be anarchy or tyranny.”
I wouldn’t necessarily say that this is a case where Republicans in Congress are disdainful of democracy since they are obviously working within the law. I would say they are disdainful of the Democrats’ agenda. The upshot here then is that polling suggests that Americans do see the Republicans as more blameworthy in this fight and I expect that a default would make this attribution to Republicans more stark in a way that would cost them votes in 2014. Boehner should fear a loss of the house and the Republicans should fear a 2014 on which Democrats control both houses of Congress, the Presidency and have the opportunity to select Supreme Court justices. That is the party calculus here.
Before I get into the economics, I would say, as a side note that on Friday I was in Maryland on the Capital Crescent Trail, a bike path that goes through the woods through Montgomery County into D.C. down to Georgetown. I rode for three miles before I hit the DC line where there was a gate blocking the path, telling me that it was closed due to the shutdown. My immediate reaction was anger. And I thought, “Bollocks, I just rode three miles on this path. It’s absolute nonsense to act like the path is shut at the DC line because of the shutdown when I was just on it in Montgomery County, Maryland.” I point this out to show you why some people are claiming that Democrats are trying to inconvenience people with the shutdown in order to gain political points. And that Obama is trying to scare people into taking his side. There is some merit to this argument. On the whole, however, I agree with the polls, that this is a Republican-led standoff. And as such, the Republicans should and will take most of the blame. If the U.S. defaults, their party will suffer greatly.
Note, three things, however. First, some Americans do not know what Obamacare is yet. Some people do not know that Obamacare is the same thing as the Affordable Care Act or exactly what these laws entail. For me, this is reminiscent of the “keep your government hands off my Medicare” line that some seniors took in 2009. That is notable in this discussion of brinkmanship.
Second, before the shutdown, 61% of polled voters were against the Obama stance that only a clean appropriations bill without conditions was appropriate for the debt ceiling standoff. Thus, while more Americans blame the Republicans for the standoff, a majority believe that a “not negotiating” stance is illegitimate.
Third, while only 11% of polled voters approve of Congress, “Americans’ approval of their own representative averages 44%”. This is the key to why a shutdown has happened and will happen again. Congress knows people are not rational in how they perceive these issues and the vast dichotomy between one’s approval for Congress as a whole and one’s approval for one’s own representative demonstrates this. I look at this as the endowment effect, where the representative is buoyed by being personally connected to the voter through incumbency. The Endowment effect “is the hypothesis that people ascribe more value to things merely because they own them.” What it means to members of Congress – especially in the Tea Party – is that they have a freer hand to pursue an agenda that is divisive, especially if their district is more supportive of it.
The economics of shutdown and the potential for default
On the economics, the numbers for a shutdown are generally pretty mild. We are over a week into this and one week is seen as shaving off between 0.1 and 0.4% of annualized Q4 GDP. I tend to take the higher numbers here because if the shutdown continues for longer, the fiscal multiplier will increase to much greater than one. You get not just the lost output but also knock-on effects: deleveraging, precautionary saving, a consumer pullback, falling asset prices, rising unemployment, a falling dollar, and rising inflation.
The worst-case scenario is default.
As of last week, when I last wrote, a US government default had risen to as high as a 10% probability. Just this morning, Potomac Research wrote that, “we have to raise our odds of a debt default to 20%, up from 10%”. So, default is a very real possibility here.
What happens if the US defaults?
First, note that the shutdown is governed by the Antideficiency act, first enacted in 1884 and updated twice in 1950 and 1982. The act prohibits federal employees from “making or authorizing an expenditure from, or creating or authorizing an obligation under, any appropriation or fund in excess of the amount available in the appropriation or fund unless authorized by law. 31 U.S.C. § 1341(a)(1)(A) ” subject to administrative and penal sanction. Translation: government workers are never authorized to spend money the government has not appropriated. That is why default will occur without raising the debt ceiling.
- Leading up to a default, people have wondered why markets haven’t been more volatile. Last week, Gavyn Davies made some good points as to why. “Asset prices are not necessarily very good at reacting in a smooth manner to changes in the perceived risk of extremely unlikely events”. He notes that while financial institutions change risk assessments, firms “do not always act on these changes in risk assessment, because it is difficult to change large portfolios quickly, and costly to buy hedges through the derivatives markets… It is only when the risk of an extreme event starts to appear very large over a fairly short horizon that they are willing to incur the costs of taking out insurance.”
- So the calculus is changing. Markets had already begun pricing in a default a week ago. And yesterday we saw T-biils auctioned at the highest yield since 2008 on the back of a default risk premium. The irony then is that the standoff increases the deficit by making funding more expensive.
- Banks are already stockpiling more cash in order to prevent a bank run from occurring. But we can’t be sure that we won’t see a massive panic that leads to runs.
- Around October 17th, the US government will run out of cash reserves. But there are a few days when the government is scheduled to take in more cash than it spends and so we can see a delay in default for a while. However, we should assume that by November 1st. The jig is up and default occurs.
- To avoid default, some like US Senator Rand Paul have argued that the US could prioritize payments. Others have suggested that the U.S. could invoke the 14th amendment to keep the government going without default. Others still point to gimmicks like minting a trillion dollar coin or creating special Obama bonds. The President has said he will not use any of these tricks.
- Regarding default, first, let’s assume that in the event of a missed payment, the US has three days to cure, meaning it won’t be a real default until three days after the event.
- That said, the markets are going to react even so and we should expect the fallout to occur even if the default is not ruled a default by iSDA, which controls credit default swap contract payout.
- If the US does default, it would join countries like Argentina, Ecuador, Greece, Liberia, Venezuela and Zimbabwe which have all defaulted on sovereign debt in the last ten years.
- The default would also mark the second – or maybe third – time that the US has defaulted. One time was in the 1700s. And the second, more questionable time was during the Great Depression when the gold link was severed.
- The key places to look are where government bonds are used as collateral in repo markets and the like. Peter Stella’s QE exit-path implications for collateral chains gives you some sense of how this market functions in a different context. In addition, JPMorgan gives one a sense of how big this market is. It is enormous. And it is this fact that makes a default a catastrophic event. This is where financial dislocation starts. And given what Davies said about market reactions, we should expect to go from no volatility to extreme volatility overnight.
- We should also note that even QE hawks like the Fed’s Richard Fisher are decrying the U.S.’s flirtation with default. Could the shutdown turn Fisher from hawk and expressed QE doubter to QE dove? I say yes. An October taper is out now. With Fisher railing against the shutdown, it may be out for December as well. Bottom line: Longer shutdown equals more QE, especially with Yellen, a QE dove taking the reigns according to press reports.
Currency sovereignty and the Ecuador risk factor
The United States is sovereign in its currency which means that the US government creates the currency of account used for payments within the United States. As such, the US government can always make good on its liabilities because it creates them by fiat, which is why the US dollar is called a fiat currency. The question is whether it is willing to do so politically.
We first came upon this in the economics blogosphere during the European sovereign debt crisis. People like Paul Krugman were wondering aloud why Italy was getting the bond market vigilante treatment while the United States was not. I explained that the answer was currency sovereignty: “the ability, not the willingness of government “to hand you another paper IOU with the exact same amount printed on it” when you present it with an obligation in the currency of account. “
This is an important point here because it tells one why the Fed exerts a dominant influence across the yield curve, not just on the short end. The Fed as the government’s agent with monopoly reserve power controls short rates and thus long-rates through the expectations channel. This caps the rise in US interest rates to the expectations channel and the volatility of the expected path of those expectations.
However, this point also tells one why the U.S., Japan and Britain have such low interest rates while Spain and Italy, who lack currency sovereignty, do not. UK government bonds are the UK’s safe haven asset class just as US government bonds are the US’s safe haven asset class. And given the US dollar’s role as global reserve currency, it explains why there will be great turmoil in markets. After all, the safe haven asset used as not just an investment but as collateral world-wide would be turned upside down. That is a potentially Great Depression-creating event of political stupidity on a grand scale which introduces default risk where none was present.
Other sovereigns have made these moves, however. For example, in 1998, when Russia defaulted on its sovereign domestic fiat currency obligations, it came as a shock to the markets because market players assumed Russia would always make good on those commitments since it could do so. Long-Term Capital Management nearly failed and we had a major financial crisis as a result. I call the political will to default on fiat currency the Ecuador risk factor because the Ecuadorean President put it well when his country defaulted in 2008: calling the lenders “monsters”, adding that “as president I couldn’t allow us to keep paying a debt that was obviously immoral and illegitimate”. That’s the kind of risk factor that you can’t model.
I am going to leave it there. We are seeing an epic struggle here that has global implications. I am not concerned about the effects of a shutdown on the global economy and asset markets. I am very concerned about a US sovereign default because I believe it would lead to a catastrophe of unknown proportions.