The Latest Washington Crisis

October 3rd, 2013

by Don Gould

In the latest partisan skirmish among our Washington legislators, we find the US government in partial shutdown. Added to that, the government has reached its legal borrowing limit (the so-called “debt ceiling”), and the Department of the Treasury says it will run out of money on October 17 unless agreement is reached to raise the borrowing limit. The confluence of the October 1 and 17 deadlines cause many observers to link the two into a single debate between the opposing factions in Congress.

The government shutdown is the result of Congress’s failure to pass a budget for the fiscal year that began October 1. The debt ceiling debate is a reprise of a similar event in 2011, which led to both the now familiar automatic spending cuts (the “sequester”) and a Standard & Poor’s downgrade of US Treasury debt from AAA to AA. As long as the US runs budget deficits, spending more than it receives in taxes, the government will need to incur net borrowing to cover the shortfall, which it does through the sale of Treasury debt to investors. In turn, it must periodically raise the debt ceiling limit to permit net additions to the total amount of debt outstanding. In the past fiscal year alone, the US added about $700 billion to its national debt.

As this is written on October 3, market response to the budget/debt dispute has been muted, though with each passing day there does seem to be rising levels of investor anxiety. (See accompanying chart.) The biggest fear is a possible default on US Treasury debt – a failure to pay interest and/or principal on existing Treasury securities. Treasurys are a linchpin of the global financial system, a benchmark by which nearly all other markets calibrate themselves. An outright default would likely be very disruptive, affecting economies and markets in ways we can’t fully anticipate.

The government has endured temporary shutdowns in the past, and we survived the debt ceiling crisis of 2011. We expect this crisis will also reach resolution in the next 1-2 weeks. Getting there, however, may be a tortuous process, with market volatility along the way. The Republican-controlled House of Representatives seems to have made a tactical error in linking any resolution to a scaling back of the Affordable Care Act (aka Obamacare), a demand that Democrats almost certainly will not accede to. As a result, it will be more difficult to craft a compromise that allows both sides to claim some victory. Possibly a more broad-based negotiation on multiple items will break the impasse.

Despite this, we believe the crisis will be resolved, and fairly soon. We have here a classic negative-sum game, where all warring parties collectively lose as the game gets longer. One side might get more than half the blame, but all sides are worse off in the end. The political cost of disagreement will become unbearable if it entails an extended government shutdown and/or a debt default, however temporary.

This is not a proud moment for the republic, but history suggests that investors are best advised to sit tight and let the storm pass, as it surely will.

 

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