On the US government shutdown

Today’s commentary

Summary: It isn’t yet clear how long the US government shutdown will last or what impact the shutdown will have. Nor is it clear that the US will escape a debt default down the road. Therefore, at this time all that reigns is uncertainty.

I have avoided commenting extensively on the US government shutdown because it really isn’t clear what impact it has had or will have because we don’t know how long it will last. The situation is not about economics but politics and ideology, making it extremely difficult to predict what is going to occur. I would like to think there is not going to be a debt default but the unpredictable nature of things makes this just a hope more than a conviction. On the whole, I see this as avoidable confrontation that makes plain how polarized the US political scene has become.

If I had to make comparisons, frankly I would have to go back to the civil war. Now I am not a historian but I do have a good understanding of the last quarter century of US politics as I have been in and around Washington during much of that time. And what strikes me as particularly important is how we are seeing repeated political episodes of brinkmanship over issues that could produce economic catastrophe. If you go back to previous US government shutdowns in the late 1970s or the early 1980s or during the Clinton administration, there was rancour but there was no threat of debt default. And I believe this is significant. For me it signifies a level of partisanship, dysfunction and ideology that is extremely dangerous – and not just for the US but for the world’s economy because of the importance of the US as an actor on the world stage.

Another comparison I could make is Suez from 1956. This was a confrontation involving nationalist Egypt and former superpower Britain that is seen by historians as the historical event marking the end of the British Empire and the UK’s position as a major power on the global stage. With the US involved in multiple theatres of war, implicated in spying on its own citizens, threatening default, shutting down government, caught at odds over a core issue of how to administer universal health care – something available in every other industrialized country, it’s clear that the US is rudderless politically. Maybe the United States will snatch back the mantle of global superpower. But I tend to think the moral authority of the US has been permanently eroded by all of these events. The question is what difference it makes.

From an economic point of view, pre-shutdown my short-to-medium term view was positive, not just for the US but globally as China and Europe had numbers that suggested global growth. Moreover, the delay of the Fed’s tapering of large scale asset purchases has been bullish for both US mortgage assets and emerging markets, lifting some of the downward pressure off their economies. I don’t see a short shutdown as something to worry about in this context. However, a longer shutdown – say over one month – would create serious problems.

According to a Bloomberg poll, one week is only worth 0.1% of US GDP as the shutdown is estimated to cost $300 million in GDP per day. This is a small amount in a $15 trillion economy. If the shutdown continues for longer, however, we would have to think about a lot of knock on effects in terms of precautionary saving, consumer pullback, deleveraging, knocks to asset prices, falls in equity market valuation multiples, rising unemployment, a falling dollar, and rising inflation. All of these effects can come into play if this crisis continues. And rather than remain sanguine that it won’t continue, we should analyze worst-case scenarios.

Clearly, the worst case scenario is a debt default – something that is considered to have risen to as high as an astronomical 10% probability despite the high debt rating for the US government. It is not clear what services or debts are prioritized in the awkward event the US government runs out of the currency it creates. If securities are in technical default, that could lead to a systemic financial crisis. Clearing systems like the Fedwire would fail because defaulted securities cannot be used. US government collateral would become less valuable, having severe repercussions on all credit markets where it is used as collateral for US dollar claims. Credit Default Swap contracts would be triggered. I should note however that there is no cross default provision so only those issues that come due in October will be defaulted on. Other US treasury issues would not have suffered from default.

This political brinkmanship is dangerous and unpredictable. In a best case scenario, the healthcare and deficit spending issues remain contentious but the US government continues to function and the debt ceiling is raised while some sort of stopgap compromise is worked out. There would be no long-term implications to the economy from such an outcome and only minor short-term ones. But there are a lot of scenarios in which lasting geopolitical and economic damage can be done. The longer this goes on, the more prominent those scenarios become and the more we need to think defensively regarding asset allocation and the economic outlook.