As debt talks broke down today, concerns were raised about a U.S. default. Maury Harris, chief U.S. economist for UBS Investment Bank, and Drew T. Matus, senior U.S. economist, UBS Investment Bank, look at the potential effects.
Decades of fiscal imprudence have led us to this point: the prospect of a U.S. government default. The U.S. Treasury continues to expect the federal government to exhaust its ability to borrow on Aug. 2, 2011. After Treasury Secretary Timothy Geithner issued a series of warnings to Congress earlier this year and implemented extraordinary balance sheet maneuvers in May to push the deadline this far, time is running out for a resolution.
Although we still do not view government default as a likely outcome, several factors are encouraging brinkmanship. The 2011 budget deal reduced outlays by a paltry $352 million despite announced cuts of $38 billion. This gap between expectations and reality has likely hardened the stance of voters and politicians who are focused on fiscal issues. In a recent Gallup poll, 47% of Americans were against increasing the debt ceiling, a figure that probably bolsters the anti-debt hike posture for many politicians who argue against an increase. According to a recent Pew Research Center poll, about the same percentage (48%) believes increasing the debt ceiling would result in “higher spending/bigger debt”. In contrast, just over a third of Americans worry about the impact a default would have on the U.S. economy.
These figures may be the result of the mistaken notion that the U.S. can continue to make interest payments in a timely manner, avoiding a default indefinitely, and keeping intact its full faith and credit. The erroneous view requires investors to willingly roll over their holdings of Treasury debt, which seems unlikely under those conditions. Additionally, it ignores the fact that some Treasury investors may actually need their money back at some point. Finally, it does not account for the sharp interest rate increase that may result.
The U.S. occupies a special place in global finance. The symbiotic relationship between the U.S. dollar as a reserve currency and the U.S. Treasury market’s monopolistic position as the safest, most liquid bond market in the world has served this country well. This unique position has allowed the U.S. to exercise significant authority in the global economy and enhanced its standing as a world power. Even a temporary default would eliminate the safe and liquid nature of the U.S. Treasury market, harming this country’s ability to exercise its power, to the detriment of the U.S. and the global economy.
The main impact on markets would come from sharply reduced liquidity in the U.S. Treasury market, as financial firms’ procedures and systems would be tested by the world’s largest debt market being in default. Given the existing legal contracts, trading agreements, and trading systems with which firms operate, could U.S. Treasurys be held or purchased or used as collateral? The aftermath of the failure of Lehman Brothers should be a reminder that the financial system’s “plumbing” matters. All the legal commitments and limitations in a complex financial system mean a shock from an event that is viewed as inconceivable – such as a U.S. Treasury default – can cause the system to stall. The impact of a U.S. Treasury default could make us nostalgic for the market conditions that existed immediately after the failure of Lehman Brothers.
Post-default liquidity could get even worse in the likely event of a rating downgrade. The liquidity event would not be limited to the Treasury market. Any reduction in the ability to use Treasury debt as collateral for loans would mean funds would need to be found: liquid assets sold to raise cash. Additionally, holders of U.S. Treasurys counting on timely payment could be forced to borrow funds in upset credit markets when those funds do not materialize.
We expect a near-term resolution of this issue. However, if the political impasse continues and the U.S. defaults, it would not simply be a question of whether Treasury investors would get their money; eventually they would. It would be a question of whether the U.S. would lose something that made it special. The answer would be yes and the consequences for U.S. growth could be significant.
No comments:
Post a Comment