Waiting for Day-X

Although there is a tentative agreement between President Biden and Speaker of the House McCarthy, it must still be ratified by Congress next Wednesday. The problem is that the Republican party does not exactly speak with one voice. Fifteen rounds were needed just to elect McCarthy speaker of the house. Already 78 times the debt ceiling of the United States has been raised. The U.S. Constitution states that only the U.S. Congress may determine how much the U.S. government can borrow. Therefore, until 1917, every U.S. government loan had to be approved by Congress, but since the Second Liberty Bond Act of 1917, only the maximum size of the debt is set by Congress. If the president and Congress are of the same colour, an increase is a hammerlock. Similarly, when there is a Republican president and a Democratic majority in Congress, there are usually no problems. Only when there is a Republican majority and a Democratic president can things pop. In the 1990s, for example, Speaker of the House Newt Gingrich took on Bill Clinton. More than a decade ago, under President Obama, talks escalated thanks to the Tea Party. That caused Standard & Poor's to downgrade the U.S. government's credit rating from AAA to AA+ in 2011 but eventually raised the credit ceiling even then.

Meanwhile, the US national debt has more than tripled and the Democrats have delayed discussion of a new increase for as long as possible, not convenient given the majority they held in Congress until recently. To govern is to foresee.

The money is running out. Over the past year and a half, the Biden administration has emptied every pot to keep going. Compared to before that, it quickly adds up to about $1 trillion that the U.S. government normally had liquid. Yellen has previously indicated that the day when the money runs out would fall around June 1, but that has since been pushed back slightly to June 5. This moment is also called X-day, a name that seems chosen more to heighten the drama or to make a movie about it later. By far the most likely scenario is that the debt ceiling will be raised. This could be through a short-term increase to give Congress longer to negotiate. There will then be no short-term impact on the economy. But procrastination does not come to an end. There will have to be negotiations. Democrats are most likely to give in to Republican demands. That means they will have to spend less, including important Biden-initiated investments. This will reduce the U.S. budget deficit but raise the debt ceiling. Even then, the effect on the economy is not so great. A party that gets the country into trouble usually does not do so well in elections. Still, the Republicans are unlikely to raise the debt ceiling without some concession from the Democrats. If they do then it will be "business as usual" and the tension now visible in the money market and credit spreads will disappear.

Given the extreme polarization and also the internal strife within the Republican party, there is a good chance that there is no deal after X-day after all. More than a decade ago, the Tea Party was a major factor, but the chaos within that party now seems complete. Conservatives, Social-Conservatives, Libertarians, Neo-Conservatives, Moderates, Liberal Republicans, the Trump factions and the anti-Trump factions are fighting each other for power. And where previously both the Democratic and Republican parties came under pressure with a rational solution in which both parties could survive, one or more factions within the Republican party may just use this moment to blow up the party. That means the U.S. government must shut down. The budget must be acutely balanced by spending less. This is not yet a default of the U.S. government. It will first cut back on items that have less economic impact, such as cutting benefits and salaries. Such a situation will, however, cause Fitch, for example, to lower the credit rating of the United States as well. It is also likely to push the economy into recession because the government can acutely spend some $1.5 trillion less (6 percent of GDP), but in such a situation U.S. government bond yields may fall, after all, a recession depresses inflation. It is even likely that the U.S. government will have to cut more than the $1.5 trillion mentioned because a recession is usually not good for tax revenues. Still, in such a situation, the U.S. government will almost certainly be able to continue paying interest on government bonds, so there will be no default.

The most extreme scenario is when a default does occur. There is then a stalemate between the Democrats and the Republicans. The sharp rise in credit spreads shows that the market is even taking such a scenario into account. A default occurs when an interest payment is missed or repayment is delayed, with an additional three-day grace period also applied. After all, continuing to pay interest on debt means that at the same time, the elderly and veterans will no longer receive money from the government, so for a politician, the choice is not so simple. But a default of US treasuries would quickly lead to chaos since US government bonds are the foundation of the current international financial system. We would get a situation similar to the problems during the Great Financial Crisis. The big difference now, however, is that a component of that crisis was that no one knew where the risks were and the U.S. Congress initially failed to pass the TARP program. This problem is much easier to solve and is also caused by Congress itself. Even if there is a default, the social reaction will force Congress to raise the credit ceiling within days anyway. Yet then the damage to the U.S. economy and the status of the dollar will be much greater, again resulting in lower U.S. government bond yields.

Incidentally, some still see a risk of the $1 trillion being replenished in the short term after the credit ceiling is reached. This means ceteris paribus an acute reduction in the money supply, just at a time when monetary policy is causing negative money growth for the first time in decades. However, there is no shortage of liquidity in the U.S. money market. Every night nearly 4 trillion is parked at the Fed just because interest rates there are higher than on government bonds. A little more interest than on repos at the Fed and then $1 trillion is also quickly found. Furthermore, these developments together with the latent banking crisis may cause the Federal Reserve to rapidly cut interest rates. Thus, there is also an advantage to the disadvantage here.