US shutdown unlikely to lead to default, Invesco’s Greenwood says

John Greenwood, Chief Economist at Invesco, analyses on the economic consequences of the partial shutdown of the US federal government.

With the Democrats and Republicans failing to reach an agreement on the budget, how long is the impasse likely to last and what are the economic consequences?

The partial shutdown of US federal government has been in effect for more than a week, and currently both sides are refusing to yield to compromise. This implies that the standoff between Republicans (who control the House of Representatives) and the Obama Administration (who need Congressional authorisation to make the payments) could continue until the Treasury uses up its entire (approved) borrowing capacity. The Treasury estimates that this would occur on October 17th, and its remaining cash balances would only suffice for another week or two at most (i.e. until month-end).

Together these two deadlines form “book-ends” for the probable most intense phase of the crisis. However, I believe it is inconceivable that either side will push the confrontation to the point where the US defaults on one or more of its outstanding obligations (e.g. repayment of principal on maturing bonds, or interest coupons on those bonds), thus triggering an outright default and initiating the process of downgrading by the rating agencies.

Such intransigence would be hugely damaging to the reputation of the United States as a borrower both in the short term, and beyond. It seems likely, therefore that the crisis will be resolved within the last two weeks of October. The resolution could either come via a bill that deals with both the current budget and the debt ceiling together, or via standard continuing resolutions (CR) and a new debt ceiling, both in return for some concession by the White House on future spending plans.

Likely economic and financial market consequences?

In terms of the direct effect on federal government employment, initially some 800,000 federal employees were temporarily “furloughed” (temporarily discharged), but already the Defense Department is reducing the number of furloughed workers. This is thanks to a changed interpretation of the definition of “essential” civilian employees, effectively maintaining about 400,000 more people in employment.

In addition, legislation has just been passed to enable furloughed workers to be paid retro-actively. These temporary “fixes” are a two-edged sword. On the one hand they ease the anxiety of affected employees, but on the other they reduce the pressure on Congress and the Administration to reach an agreement.

Even so, the direct impact of the federal employee layoffs is reducing the GDP by around $160m each workday, and when other effects (such as deferred contracts, closure of private businesses directly dependent on government, and related disruptions) are added, the total is more than doubled -around $1.6bn per week compared with an annual GDP of $15.7trn. As Bloomberg expressed it, this Washington-made calamity is on a par with a natural disaster such as the recent Colorado floods that cost the $2bn. If continued it would be like one hurricane per week for as long as the stand-off lasted.

The impact on markets is much more difficult to gauge. While some holders of Treasuries may sell down their holdings, or buy less in the future, this was not what happened in the summer of 2011, the last time the Congress refused to extend the debt ceiling.

On that occasion expectations of damage to economic activity caused a “growth scare”, prompting investors to sell equities and buy bonds – including Treasuries – as a safer alternative. The US dollar even strengthened between August and October 2011. In short, the perceived safe haven qualities of US Treasuries and the currency won out over concerns about the creditworthiness of the US Federal government.
A similar outcome is entirely possible on this occasion, although the better economic fundamentals of foreign economies make the currency more vulnerable this time.

 

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