The Dow was down 70.06 points, or 0.46 %, at 15,258.24. The S&P 500 was down 6.93 points, or 0.41 percent, at 1,691.74. The Nasdaq was down 5.83 points, or 0.15 percent, at 3,781.59. For the week, the Dow ended down 1.3 percent, the S&P 500 fell 1.1 percent while the Nasdaq ended up 0.2 percent.
The markets have been strangely complacent regarding these two upcoming self-inflicted crises. We believe the government shutting down would be the lesser of the two evils since if that happens the outcry from the affected members of the U.S. public will be enough to force passage of yet another stop-gap bill. It is the debt default that worries us most, and with that in mind, let’s look at what might happen in a shut down and what might happen in a debt default.
September 30 is when the continuing resolution sending money to the various federal agencies would expire, and with it the government’s “spending authority.” A shutdown would not affect “mandatory” spending — meaning money for Medicaid, Medicare, Social Security, unemployment insurance, food stamps, tax credits and a few other programs, but it would put a halt to “discretionary” spending, meaning everything else, from national parks to the Education Department to visa offices. Hundreds of thousands of employees would be put on furlough, and much of the federal government would go offline.
There are some exceptions. Self-financing agencies, like the Postal Service, would remain at work, as would safety-related agencies like air traffic control, food inspection, federal prisons, disaster assistance, border security and veterans’ hospitals. All in all, not catastrophic for the U.S. or world economies, if the duration were short.
As for the debt default, the date on which the federal government runs out of room under its statutory debt limit, the Treasury would find itself unable to make all that day’s federal payments. This date is often referred to as the X-date. To be clear, that is not “hitting the debt ceiling.” That happened on May 19. The government has stayed about $25 million below the $16,699,421,000,000 limit since then through various “extraordinary measures” that have let it free up about $300 billion in cash. But those “extraordinary measures” cannot last forever. One day — sometime in late October, probably, though nobody knows exactly when — cash going out will overwhelm cash coming in plus cash on hand. The government would keep missing payments, about 30 percent of them, until Congress raised the debt ceiling again.
Why would the X-date be worse than a shutdown? One main reason is uncertainty. The various federal agencies and departments are required to keep contingency plans in case of a shutdown. Thus, a shutdown would be very inconvenient for those trying to get a visa, be hired or paid by a federal department, or watch the elk in Yellowstone, but it would be orderly in Washington. Employees would know whether to head in to work or not. Critical functions would remain online. The markets might not like it, but they probably would not panic, either.
Congress failing to raise the debt ceiling before the X-date is another story. There is really no playbook there. It is not certain when it would happen. It is not clear what payments would be missed. The Treasury makes more than 80 million of them a month, after all.
The best information comes from a Treasury inspector general report from last year. It indicated that the Treasury Department had rejected the idea of cutting all payments across the board, to keep money going out equal to money coming in. “Prioritizing” payments — paying bondholders first, for instance — might be difficult, given that the Treasury payment systems are not built to do so and there is no legal argument for doing it. Delaying payments would be the preferred option, the report indicates, but there is nothing like an agency-by-agency plan.
In response, the financial markets will probably panic. They might not. Some financial experts argue that a few missed payments that spurred immediate Congressional action to lift the ceiling might not be so bad, but many, many others, including us, foresee a financial tsunami that would raise the country’s borrowing costs, send investors scrambling for safety and deeply injure the United States and global economies.
There is no real comparison between the cost of a shutdown and the cost of a breach in the debt ceiling. The two shutdowns of the Clinton years — a six-day shutdown in 1995 and a 21-day shutdown between 1995 and 1996 — cost about $1.4 billion. A more complete accounting suggests that is on the low side. Nevertheless, employees and contracts would eventually be paid. Spending by the public that did not go to national parks might go to state parks instead. The damage would be fairly minimal in the context of a $16 trillion economy, especially if the shutdown were short.
In contrast, a breach of the debt ceiling and the ensuing market gyrations might cost hundreds of billions, perhaps more. For one thing, it would raise the United States’ borrowing costs, with investors demanding more in exchange for their cash. How much more, we do not know. But a 0.5 percentage point increase in Treasury rates — from 3 percent to 3.5 percent, for instance — would eventually cost about $75 billion a year. That would be bad enough, but the related costs to the economy could be far, far worse. The price tag on a huge range of other debt products is benchmarked to the cost of Treasuries. That means a spike in the federal government’s borrowing costs would translate into pricier mortgages, car loans and corporate borrowing costs. What that means is a slower recovery.
There would be other second-order effects as well. Investors dumping stocks and fleeing to cash might depress business confidence and depress the wealth effect of the recent run-up, for instance. International markets would feel the pain too. In addition, it might not even take reaching the X-date for the government to see higher costs related to the debt ceiling, either. The Government Accountability Office has estimated that the debt ceiling showdown of 2011 cost taxpayers $1.3 billion in that fiscal year alone. The Bipartisan Policy Center pegs the cost at $18.9 billion over 10 years. That’s $18.9 billion over 10 years for a debt default that did not happen.
As you can see, the potential consequences of a public debt default could be quite serious and long-lasting. Unfortunately, there is no way to predict exactly, thus a huge amount of uncertainty exists and this does not yet seem to be priced into the markets.
While we do not generally put out “calls to action,” we would urge those of you whose Congressional Representatives are among those pushing to allow a default to contact that Representative and let them know it may not be such a good idea.
Next week we will be watching the two showdowns, as well as the following economic data: the ISM Manufacturing Index report, the ADP Employment report, Jobless Claims, and Ben Bernanke’s speech.
If you would like links to or copies of the research that went into this writing, please contact me via email.