US debt ceiling: deal or no deal?
10th October 2013
In 2010, a customer asked me what would happen if America defaulted. I said that it didn’t bear thinking about. We no longer have that luxury. The stalemate over America’s “debt ceiling” means there is a risk that the US Treasury will run out of money this month, which brings the chilling possibility of default. To be clear: we don’t think this will happen. Our best guess is that a deal will be done and the storm will pass. And even if there is no deal, we think deep spending cuts are more likely than default. But this would still cause a US recession, with adverse implications for people and businesses in the UK.
What is the debt ceiling and why does it matter? In the UK, the Government can borrow as much money as investors are willing to lend it. Not so in America, where Congress imposes a limit on how much can be borrowed, called the “debt ceiling” (currently $16.699 trillion). It has been raised 94 times since 1944, most recently in 2012. The 93rd increase, in 2011, went right down to the wire. This cost the US its AAA status but not much else. The US Treasury reckons it will reach its limit on 17 October. If politicians do not agree to raise the debt ceiling, they will quickly face some difficult decisions.
What happens if politicians don’t raise the debt ceiling? In theory, the US could engage in “creative” solutions to get around the political impasse. For example, the Treasury could mint a $1 trillion platinum coin and use the proceeds to fund government spending. Or President Obama could ignore the debt ceiling by invoking an obscure section of the 14th Amendment intended to deal with Civil War debt. But these and other creative solutions are not under serious consideration. Instead, the US would instantly have to start living within its means, spending no more than it raises in taxes.
That might not sound like a bad thing, until we consider what it means in practice.
America spends about $1.18 for every $1 of revenue. To bridge that gap, it borrows. If that was no longer possible, there would be two broad options. First, America could refuse to pay its debts. Since US Treasuries are the bedrock of the global financial system, default would send markets into a tailspin which could eclipse the events of 2008. With the costs of default so great the incentives to avoid it are extremely powerful. This leaves the second option: deep cuts to public spending on pensions, contracts with businesses and the public sector payroll. The fall in demand alone would cause a recession.
But that would almost be the least of our worries. Letting matters get to the point at which deep cuts happen would confirm that the US political system is so dysfunctional that it cannot make one of the most basic decisions of a government: how to manage its finances. Markets would be unimpressed and there could be a sharp rise in borrowing costs and a big fall in the dollar. So, it’s no surprise that China, which holds more than $1 trillion in US Treasuries, recently urged America to resolve the stalemate.
Presumably the Fed would respond with more quantitative easing (QE) and forward guidance, but outgoing Chairman Bernanke has already intimated that it would struggle to contain the fallout. Of course, it’s conceivable that markets would move the other way. If the US was seen to have resolved its fiscal conflicts, however dysfunctionally, it is possible that it would still be perceived as a safe haven, and the dollar would strengthen as investors flocked to US assets.
This ambiguity is what’s so scary about this scenario; the spillovers are unquantifiable and highly unpredictable.
What does this mean for people and businesses in the UK?
Trade: America is the UK’s single biggest export market. Companies with exposure to government contracts would suffer a direct hit, particularly from the Department of Defence, where aircraft manufacturing and engineering services are the biggest vulnerabilities. But the ensuing recession would indirectly affect firms across the economy, whether they export to the US or not. Petroleum, medical & pharmaceutical products, power generating machinery & equipment and road vehicles are the UK’s biggest exports to the US. If the pound strengthened against the dollar, exporters would struggle even more. There would be some benefit for importers, as dollar-priced goods and services fell (e.g. oil).
Interest rates: If US bond yields spike, history says it’s a good bet that UK rates would follow suit. In effect, borrowing costs for British households and businesses would rise without the Bank of England lifting a finger. We should expect more QE from the Bank but, as in the US, it would be difficult to ward off the full effects of a US-inspired downturn. Also, note that the UK interest rates might rise by less than US Treasuries, and even fall, if sterling remained a safe haven.
Contagion: Perhaps the biggest risk to the UK is that trouble in America reignites the EZ crisis. Not only would that hobble demand in our other core export market it would raise concerns again about the future of the euro and the single currency’s banking system. More generally, equity prices would surely fall as markets went into “risk off” mode.
This material is published by The Royal Bank of Scotland plc (“RBS”), for information purposes only and should not be regarded as providing any specific advice. Recipients should make their own independent evaluation of this information and no action should be taken, solely relying on it. This material should not be reproduced or disclosed without our consent. It is not intended for distribution in any jurisdiction in which this would be prohibited. Whilst this information is believed to be reliable, it has not been independently verified by RBS and RBS makes no representation or warranty (express or implied) of any kind, as regards the accuracy or completeness of this information, nor does it accept any responsibility or liability for any loss or damage arising in any way from any use made of or reliance placed on, this information. Unless otherwise stated, any views, forecasts, or estimates are solely those of the RBS Group’s Group Economics Department, as of this date and are subject to change without notice. The classification of this document is PUBLIC. The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. The Royal Bank of Scotland plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. © Copyright 2013 The Royal Bank of Scotland plc. All rights reserved.