Few short-term consequences from the shutdown and debt ceiling impasse
Summary: Below are some brief thoughts on the consequences of the US government shutdown and its aftermath. In general, I believe the consequences are more likely to be political and long-term without any significant short-term implications outside of a 0.5% drop in in annualized quarterly US GDP growth.
The US debt ceiling crisis is over for now and there are unlikely to be any large immediate economic consequences. However, I believe an episode of this magnitude is unlikely to occur without longer-term repercussions. I would like to outline some of the potential implications below.
The government shutdown and debt ceiling crisis was a manufactured crisis of political choice rather than one foisted onto the scene by external events. This is not like the European sovereign debt crisis in which we saw that Greece was rendered insolvent because of a lack of sufficient euro government revenue. No one doubts the ability of the US government to pay federal workers and US sovereign debt obligations, not least because the US is sovereign in its own currency of account that the government creates. Put simply, US dollar liabilities are merely IOUs to repay with another US government IOU of the same notional value either on demand, as with cash currency, or at some later date in accordance with a debt contract. All fiat currency is similar. British Pound notes put this well as it is clearly stated on a 10 pound note, “I promise to pay the bearer on demand the sum of ten pounds”. There are no other obligations. The British government can manufacture more pound IOUs as the Bank of England has in fact done via quantitative easing. And the US governemnt can do as well – in infinite quantities if so desired.
The ability of government to manufacture fiat currency IOUs without some sort of limitation makes some uncomfortable out of scepticism about government’s ability to allocate resources efficiently. The worry is that funds will be misspent via waste or political patronage. And so some governments impose artificial constraints outside of the legislative process on a government’s ability to manufacture these IOUs. The debt ceiling is such an artificial limitation. A number of Republican members of Congress have used this debt ceiling limit, therefore, to try and stop the newly legislated government-funded healthcare plan from going into effect, with a background agenda of also cutting government expenditure writ large. Now many do not understand these basic facts and believe that a sovereign government that creates its own currency can run out of money. Others believe that creating dollar IOUs out of thin air en masse eventually leads to hyperinflation. However, hyperinflation only occurs in specific politico-economic circumstances. And the United States is not and probably will not be in those circumstances anytime in the near future. But the ideological opposition to big government will always drive the agenda to cut government spending irrespective of specific economic outcomes.
The House Republicans made their gambit knowing that voting constituents in their own Congressional districts wanted to stop government-funded healthcare and reduce the size of government. And this is what matters most for some individual members of Congress irrespective of the national party political consequences. Nonetheless, it was clear from the start that this gambit would fail because the President was not going to give in on his signature legislative accomplishment and he had support on this from the Democratic-controlled Senate. What was also clear was that the House Republicans were going to do this anyway to make a point because they believe repeated bouts of this kind will have an incremental effect in decreasing the pace of growth in the US federal government. That alone assures that this battle would happen and that future battles like this will happen. The next debt ceiling battle will begin in February or March.
Looking at this picture holistically, the futility of the shutdown and the brinkmanship over default has done significant damage to the Republican political brand and the Republican’s political agenda. First, President Obama had been floundering due to political scandals involving NSA spying, a failed attempt to gain authorization to bomb Syria, and a misguided attempt to install Larry Summers at the helm of the Federal Reserve. From a party perspective, it would have made sense for the Republicans to use this weakness as leverage toward achievable goals that had significant national voter appeal. But this battle was both unwinnable and unappealing because the threat of default caused national embarrassment. Second, because the leaders of this movement are also the leaders of Republican movements against bank bailouts and NSA spying, the unpopularity of the default threat damages the Republicans ability to gain traction on those other issues. The Tea Party members of Congress are now tarnished with an ‘extremist’ image that makes them less effective on other legislative items. Third, while national elections are still one year away, I believe the spectacle of members of Congress shutting government down for three weeks and threatening to allow a sovereign default will be an issue that sways independent voters away from the Republican Party. As such, the Senate may be unwinnable. Instead, the Republicans have to fear losing the house.
In sum, the debt ceiling crisis has boosted ratings for President Obama, taken the heat off of the President at a critical juncture and dimmed the image of the Republican party as a governing party. None of these points will have specific political consequences in the near term. However, over the longer term and in the next election, it will boost Democrats and their agenda.
On the economic front, the government shutdown and crisis may not have any lasting consequences. Yesterday, I wrote that US growth is on track despite the debt ceiling impasse. And I expect GDP growth to come in just shy of 2% after shaving somewhere in the region of 0.5% from annualized Q4 2013 US GDP growth. Now, even before the crisis began, I believe we were past the business cycle economic peak. Lance Roberts’ post on retail sales adds to this view. So, the slowdown in growth we see will not all be attributable to the government shutdown.
Nonetheless, I believe that the fiscal multiplier is still high in the US because psychologically, private sector agents are still scarred by the financial crisis. Moreover, household debt is high, unemployment is above trend, capacity utilization is below peak. It does not take a large exogenous shock to combine these weaknesses into a consumer pullback, a drop in credit growth, and a weakening in hiring trends. In fact, economic confidence has been dented and my former employer CEB has done a survey of US business and found that hiring expectations have been as well. This means that the economic consequences of the shutdown will be longer lasting and greater in magnitude, something that is bullish for Treasurys.
From a political perspective, it is not clear to me that the message learned by the Tea Party is “hold back”. I expect more debt standoff encounters in the future and I expect these encounters to have a negative impact on government spending unless the deficit comes down more quickly than anticipated.
Beyond these factors, I don’t see any lasting economic effects.
The recent Chinese rhetoric about moving away from a US-centric economic environment is pure opportunism. I don’t expect anything to change n the near term. Moreover, the Chinese policy of exporting China’s way to growth means it must accumulate currency reserves and therefore that it must hold US dollar assets. The Chinese are committed to growth and reversed their economic rebalancing agenda and reverted back to the export and infrastructure-led growth model as soon as growth was threatened. So, the Chinese rhetoric on moving away from dollars is pure propaganda and has no basis in economic reality.
On the other hand, over the longer term, it is now clear to everyone in the world that the US does not act responsibly with the power it has as an actor on the world stage. The negative effects of quantitative easing on asset flows into and out of emerging markets, the indiscriminate spying on individuals and foreign business alike and the threat of sovereign default all reinforce the notion that the US is not to be trusted. Right now, there is no counterbalance to the US on the world stage. However, economically, the Chinese are not the only pretender to the throne; the EU and eurozone are very much projects to counter US hegemony. I believe the debt ceiling crisis will only help redouble European efforts to continue pushing forward with integration. Every time the EU comes together, America’s abuse of power and volatility will be a perpetual theme to give impetus to European cohesion. This is a major reason we should not expect a wholesale collapse in the eurozone anytime soon. A retreat from the euro would leave Europe diminished on the world stage and beholden to US power.
In the meantime, we now move to earnings season which is just getting underway.