We are getting closer to global financial chaos

Last week the White House released a paper outlining the potential effects of the various debt ceiling scenarios, ranging from brinkmanship that averts a default at the eleventh hour, to a short-lived default to a protracted one.

In the least-worst scenario, 200,000 jobs would be lost, real economic growth would be trimmed by 0.3 per cent and unemployment would rise by 0.1 per cent.

If the outcome were a “short default” half a million jobs would go, real GDP would be cut by 0.6 per cent and unemployment would rise by 0.3 per cent.

In the event of a protracted default, the cost would be 8.6 million jobs, a 6.1 per cent fall in real GDP and a 5 per cer cent increase in unemployment.

Any default would limit the government’s ability to act to blunt the economic effects because it would be unable to borrow. The economic downturn would also likely impact the ability of households and businesses to borrow and, in any event, interest rates would “skyrocket” for the government, businesses and households.

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The White House paper cites an analysis by credit ratings agency Moody’s that even with a brief default interest rates would spike, equity prices would plunge and short-term funding markets would probably shut down.

It also referred to a Brookings Institute paper that said the damage to the perceived safety and the liquidity of the US bond market could translate to more than $US750 billion of increased federal government borrowing costs over the next decade.

A simulation run by the administration’s own Council of Economic Advisers (CEA) concluded that a protracted default would generate an immediate, sharp recession of the order of what the Americans call “the Great Recession,” or the economic downturn the US experienced between December 2007 and mid-2009 in the midst of the global financial crisis.

During that period GDP fell about 4.3 per cent, the unemployment rate reached 10 per cent and US household net wealth fell by more than 17 per cent. It wasn’t until 2016 that the jobs lost during the Great Recession were fully recovered.

The CEA simulation also showed the US stockmarket – a market that influences most international equity markets – plummeting 45 per cent.

US financial markets, and the US bond market in particular, influence global financial activity. Most financial assets are ultimately benchmarked against the “risk-free” US 10-year bond rate and the US market has, in the post-war period, been the world’s financial safe haven.

If faith in US Treasuries were shaken, or indeed lost, it would reverberate through global financial markets, likely causing chaos and loss.

The US dollar’s status as the world’s reserve currency, which China, Russia and others are already doing their utmost to erode, would also be threatened if the US government were unable to pay its bills.

Merely flirting with the prospect of a default is damaging to the credibility of the US bond market and the dollar and is encouraging flows out of the market and the dollar to assets regarded as less risky.

The White House paper cites an analysis by credit ratings agency Moody’s that even with a brief default interest rates would spike, equity prices would plunge and short-term funding markets would probably shut down.

The gold price, for instance, is at near-record levels. The dollar has been sliding in recent weeks and is down more than four per cent, on a trade-weighted basis, from its March peak (although the US regional banking crisis might also be a factor in that decline).

Previous episodes of brinkmanship over the debt ceiling have always been resolved without a default, albeit not without some concessions from the incumbent president and some collateral damage. In 2011, for instance, the US AAA credit rating was downgraded by Standard & Poor’s. Another downgrade would by itself raise the cost of debt for all US borrowers.

There are some obscure pathways to an avoidance of the breach, although anything less than congressional authority would be controversial and embroil the administration in a constitutional crisis.

The hope is that Biden is able to convince the Republicans to separate the debt ceiling issue from negotiations over future – not previous – government spending, committing to reduce government spending materially in the budget for the 2023-24 fiscal year that starts on October 1.

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It should be noted that the biggest increase in the levels of US Government debt that the Republicans are trying to use as a lever to force Biden to slash previously approved spending occurred during the Trump administration, a Republican administration. The Democrats approved increases in the ceiling during the Trump presidency, when government debt rose by $US7.8 trillion, or nearly 25 per cent of total national debt.

Neither Biden nor his party are prepared to accept the Republicans’ demand for savage cuts to his program and McCarthy owes his position as speaker to the alliance of fiscal hardliners and MAGA fanatics which is determined to force Biden to succumb.

For some of those in that alliance it appears that humiliating Biden and the Democrats and being seen to have unravelled their “woke” agenda – is more important than the damage a default would do to the economy.

That is why there are those within financial markets and the political sphere who fear that this time might be different – that the current confrontation involves something more than brinkmanship and therefore the dreaded prospect of a default is more realistic and threatening than it has ever been.

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