What are the odds of Congress really letting the U.S. default?
As of Friday morning, they seem a bit lower.
House Speaker John Boehner and President Obama met on Thursday afternoon to discuss a Republican proposal to introduce a bill that would raise the limit until Nov. 22, the Friday before the U.S. Thanksgiving. It would be a “clean bill,” without ad-ons about de-funding or postponing Obamacare or provisions to cut spending, and it would serve to buy the parties a little time to work out a larger compromise on fiscal policy. The meeting ended inconclusively, but it’s a very good sign that House Republicans and the White House are talking.
U.S. Senators have advanced proposals for raising the debt-ceiling for either three months or a year. In general, though, the Senate seems uncomfortable with the idea of pushing up the debt limit without addressing the government shutdown, which seems to be the latest House Republican strategy.
Irish betting site Paddy Power is now listing the odds of the U.S. lifting its debt-ceiling at 1/5 ($1.20 return for $1 stake) and the odds of default at 3/1 ($4 for $1 stake). On Oct. 4 the odds of default were 7/2, meaning a return of $3.5. Gamers too, it seems, see default as a little less likely.
Does the White House have some executive power up its sleeve or a plan B to overrule Congress and avoid a catastrophe at the 11th hour?
Technically, yes. Realistically, no.
There are two ways in which the executive could hypothetically overrule the impasse in Congress. The first is the platinum coin idea, which first became popular in the 2011 debt-ceiling crisis. An oversight in a 1997 law gives Treasury the power to mint platinum coins “in such quantity and such variety” as it deems appropriate. Why not, then, goes the theory, mint a $1 trillion coin with which the U.S. could keep paying its bills? Short answer: Because the Federal Reserve has already said it will not accept it as legal tender.
Alternatively, there is a legal argument for the president simply overruling the debt-ceiling. It is illegal for the U.S. to spend past its self-imposed cap, but it is equally illegal for the federal government not to honour its debts. The White House, some scholars maintain, could solve the conundrum by picking the less damaging illegal option: Paying the government’s bills. It sounds sensible, but it’s just the other side of the platinum coin: Both options would overstep Congress’ power to control the strings of the public purse and likely trigger a constitutional crisis and endless lawsuits. The political mayhem could well spook investors just as much, or even more, than an actual default would.
Would a short-term, selective default trigger a credit downgrade?
Even a debt-ceiling breach of a week or two during which the U.S. Treasury keeps making principal and interest payments to bond holders might hurt the U.S.’s rating.
That said, if there is a downgrade, it probably won’t be from Moody’s. Of the three big rating agencies, Moody’s seems the most chilled out: In a widely circulated memo dated Oct. 7, it said the U.S. would keep its AAA rating as long as it pays bondholders. The agency noted that the U.S. is in a better position today to to meet its obligations to investors than it was during the debt crisis of 2011 because the U.S. gap between revenues and outlays is considerably smaller. In the fiscal year that ended September 30, 2011 the deficit was $1.3 trillion, or 8.6% of GDP. Now stands at about $600 billion, or roughly 4% of GDP.
Standard and Poor’s, which downgraded the U.S. to AA+ in 2011, has kept its U.S. outlook at “stable,” but has said it will lower the rating to “selective default,” or SD, if the Treasury misses any debt payment.
Fitch is the gloomiest. Its rating is still AAA, but the outlook is negative. The agency has said it will consider a downgrade if Congress doesn’t raise the debt limit in a “timely manner,” that is, several days before Oct. 17, when the Treasury has said it will run out of wiggle room. Keep in mind that S&P downgraded the U.S. even if the government had already raised the debt limit.
What effect would a default have on financial markets and internationally?
Hard to say because a U.S. default — short or long — has never happened before. But here are some ideas:
Interest rates: Rattled investors could start demanding higher returns for lending out their money. Long-term interest rates could rise abruptly, as bond prices fall. That’s dangerous for pension funds and other large institutional investors across the world, which have been loading up on bonds, and longer-term bonds to boot. The International Monetary Fund estimates a sudden, 1% climb in long-term interest rates would shrink the value of global bond portfolios by $2.3 trillion.
Spiking interest rates could also trigger a capital flight from emerging markets, much like the one we saw earlier this year when talk of the Fed shrinking the size of its bond-buying program pushed up yields in advanced economies. Investors could decide to ditch investments in the developing world both because higher rates in rich countries would make those investments comparatively less attractive and because their appetite for risk would likely drop in case of a U.S. default.
Liquidity: The mere prospect of default is having an impact on the $5 trillion repo market, where big banks and investors get short-term loans using their holdings of Treasury securities, mostly T-bills, as collateral. (T-bills are essentially short-term IOUs the U.S. government sells at a discount. The return to the holder is the difference between what the Treasury pays at maturity and the lower price for which the investor bought the bill.) Concerned about a U.S. default, some big banks and investment funds have been offloading T-bills that mature on or around Oct. 17. Now that House Republicans are talking about a temporary debt-ceiling lift, the focus has shifted to Nov. 22. Either way, the repo market is becoming less liquid.
Currency movements: Investors could also drop the dollar and flee toward other safe-haven currencies. A U.S. dollar depreciation is another way in which the value of investments in Treasurys could shrink. As the Christian Science Monitor noted, that’s probably a more realistic concern for China, which holds $1.3 trillion in U.S. government bonds, than Washington missing interest or principal payments. The other part of the currency equation is the appreciation of “safe” currencies, like the yen. This, Tokyo has warned, would hurt Japanese exports and could undermine the country’s recovery. The question here is whether the dollar would quickly climb back up once the debt limit is lifted.
Will Canada suffer?
Normally, Canadian bond yields roughly trace U.S. bond yields, so you’d think an interest rate spike south of the border would provoke one here, which could hurt indebted Canadians and the housing market. CIBC’s Avery Shenfeld, however, notes that Canadian bond yields could move the opposite way this time. In case of a serious default, one in which the U.S. postpones or suspends any debt payments, “Canadian yields could actually drop as a result of both the economic slowdown and safe-haven flows,” Shenfeld wrote in a recent research note. And, much like in Japan, an investor “flight to safety” could push up the loonie, hurting exporters.
Still, the spillover effects of a default might be contained as long as the U.S. doesn’t miss any interest payments or large bills of other kinds. Treasury should be able to get by for a week or two after Oct. 17, Shenfeld figures, but could run into trouble in November. On the first day of that month $55 billion in Medicare, Social Security and military payments comes due. The U.S. would have to skip paying bondholders or trim overall spending by 4% in order to match revenues and outlays. This would be “enough to risk at least a short-term recession in the US,” and possibly one in Canada too.
Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy.