As the expected time at which the US will hit the current debt-ceiling approaches, with no sign of a deal, market participants’ guess at the probability that debt obligations will be defaulted on rises too. This will act like a monetary contraction, a credit-squeeze, and will put compounding pressures on financial institutions and the sovereigns that back them. Default threats like this also act just like expropriating taxes of the sort that the Tea Party Republicans balk at.
The debt-ceiling worries change what it means to be the holder of a US Treasury. There are no shops in Bristol that I have found that will accept US Treasuries as a means of payment. (Many accept the Bristol Pound, so they are more experimental in their means of payment than most). But in financial markets, they perform most of the functions of money. Until now, they have been presumed to be virtually default-risk free. And this means that holders presume other people will presume that their US Treasury will be default-risk free, and so on. Because of this, prospective holders can predict with great certainty what they are likely to get for their Treasury when they decide to swap it for something they really want, (like cash to pay their extremely well paid dealers in, er US Treasuries, for example). The fact that a prospective holder of a US Treasury guesses that future buyers of the Treasury in question will make the same calculation, makes him or her even more confident of the eventual sale price. And so, on, ad infinitum. Hence Treasuries were a great way to store wealth and pay for things.
As the debt-ceiling approaches, these qualities of US Treasuries erode. They become less money-like. Whether or not a deal is done, the erosion of the money-like qualities of Treasuries is likely to be long-lasting.
The debt-ceiling is operating, therefore, like a contraction in monetary services. And it is entirely natural that this is part of the reason why the Fed backed off its earlier hint that it would soon begin ‘tapering’ (reducing the pace of) its asset purchases. That way, it can offset the contraction in assets that provide monetary services by creating new ones. Another way of putting the same thing is that debt-ceiling worries will incrase the marginal cost of funds for those lending to households and consumers, so rates paid by those borrowers rill rise. A loosening of unconventional monetary policy might hope to reverse this somewhat.
For a given amount of risk in the world that a typical investor has to try to protect against, the debt-ceiling leaves investors more exposed to risk. Crudely, there is a reduction in the quantity of safe assets.
But, potentially, the amount of risk around does not stay the same, even if the fundamental drivers of productivity, tastes in the world economy, haven’t changed. To some extent the debt-ceiling worries may operate like the collapse of Lehman Brothers in September 2008. Olivier Blanchard spoke about this in his interviews with UK radio following the publication of the latest World Economic Outlook. Actually he was careful to distinguish the debt-ceiling worries, and a possible default, from a Lehman’s event. The distinction he drew was that the panic then was caused by the fact that no-one knew precisely where the exposures to the newly-worthless subprime mortgages were falling, and precisely what those exposures were. By contrast, we have much better knowledge about who has US Treasuries, and, although Blanchard didn’t say this in the interview I listened to, we presumably can also much better quantify those exposures.
However, there is a similarity with a Lehmans type event. Suppose I consider whether to expose myself to an investment bank. I may know roughly what their US Treasury holdings are. And I may know something (presumably less) about the holdings of the counterparties to which they are exposed. And so on. However, I may know a lot less about their need for certainty in their short-term funding needs. I know how much they have got, in other words, but I don’t know how much they need. Because to know that I have to know the rest of their balance sheet intimately. And not only that, I have to know how much their counterparties need, and so on. And not only that either, because I also have to worry about what other people know about the investment bank I am going to deal with, because the chance that they will be there to repay their obligations to me will depend crucially on that.
Going back to the crude stories about the rates paid and offered by those who lend on to households and firms: spreads will rise, forcing up the rates paid by these end-borrowers further, perhaps by a great deal if there is actually a default. The contraction in monetary services and increase in risk will depress demand pushing downward pressure on inflation. But the increase in risk and spreads will also be trade-off inducing, strangling supply as firms are starved of credit, in exactly the same way that the 2008 crisis was.
The what-ifs in this post don’t have to stop there. To the exent that the debt-ceiling worries and a possible default threaten the health of large financial institutions in the US and elsewhere in the developed world, this is going to put pressure on the sovereigns that stand either implicitly or, especially since the crisis, explicitly. Compounding the worries about their ability to make-good on the promise to repay, and so-on, back through the logic traced out above.
Finally, to explain the title of this post. I read a fascinatingly scary piece by Newt Gingrich about how endowing the Congress with the power to set the debt ceiling was the Founding Fathers’ wise precaution against the tyranny of Presidential government that would ‘preserve liberty’. This ‘liberty’ is presumably a reference to the desire to keep citizens free from arbitrary taxation.
No doubt the founders did not foresee the development of integrated financial markets and the role of public monetary liabilities in ensuring their smooth functioning. If they had, they would not have allowed Congress to be able to threaten default in this way. Because this threat, and of course its execution, wipes out the value of private citizens wealth through the interdictions in the flow of monetary services, and all the consequent effects explained above. Such events are expropriations of exactly the same kind that Tea Party Republicans balk at when they come in the form of conventional taxes. Worse, in fact, since CEOs can get an accountant to check how much poorer a tax will make them. They are probably also much greater in their effects – at least in some plausible scenarios sketched above – than the difference between the two sides’ ideal profile for taxes.