Us Debt Default – Where to from Here?

Listener: 22 August, 2011.

Keywords: Macroeconomics & Money;

How much theatre was involved in the congressional fracas over the raising of the US debt ceiling is hard to tell. Had the ceiling not been lifted, the unthinkable – or, at least, the unpredictable – would have happened, so perhaps the politicians were posturing, expecting a resolution while making sure that they would be seen to be “principled”.

A parliament giving conflicting directions is not unusual. Our Parliament passed the Consumer Contracts and Consumer Finance Act but failed to provide the Commerce Commission with enough resources to properly enforce it. The difference between this inconsistency and the US Congress committing itself to spending without providing the means to pay for it is that the latter would have caused not just New Zealand credit users to suffer but the whole world.

The more limited outcome, if a deal had not been cobbled together, would have been the US Treasury stopping paying its bills, some 80 million of them every month; many Americans would have found themselves without revenue and the economy would have contracted. The game of chicken their congressmen and women have played has probably weakened the US economy anyway – but not as much – and the people in the rest of the world will suffer as they export less there.

The bigger worry (if you were not an American receiving one of those cheques) was that at some stage the US Treasury would have had to suspend paying the interest on its Treasury bills (also called T-bills or treasuries), which are the main way it finances its debts. The US Treasury would then have been deemed to be in some kind of default.

Many countries have reneged on their debt (not us, though), but the T-bills are not just ordinary sovereign debt. An easy way to think of them is as almost a currency for the international financial system. Imagine if you woke up one morning to be told the Government would not honour any of your notes or coins. That’s the type of prospect the international finance market was facing.

Many international banks have T-bills in their balance sheets. If these bills were downgraded too far, they would no longer classify as reserve assets and would have to be disposed of. Perhaps there is a quick fix for that, but the banks and other international financial institutions also depend on T-bills for their “repo” (sale and repurchase) agreements that fine-tune their overnight balance sheets.

With a reduced use of T-bills in repo transactions, financial markets might jam as they did in August 2008 following the collapse of financial services firm Lehman Brothers; this time the US Treasury, which played a central role in the unjamming three years ago, would instead be paralysed.

So, have we been saved by the congressional deal? The answer is, I fear, temporarily.

The US Congress could have another hissy fit. That is why Standard & Poor’s downgraded the credit rating on T-bills (to New Zealand’s level). Bankers will be looking for alternatives to the US treasuries. But what?

Not the Chinese renminbi, for China has far too many capital controls. Perhaps the yen, except Japan has an awful lot of sovereign debt. Sterling? Well, the UK is a skilled broker between everyone rather than offering a currency in its own right. The euro? But that system does not really have treasury-type bills.

The better bet might be Germany’s sovereign debt, which is denominated in euros (although whether it would want that role is another matter). But the euro zone is in difficulties because some of its economies – Greece, Spain and Italy are in today’s headlines – are heavily over-debted while the sound economies, notably Germany, have been unwilling to bail them out (that is, to take a share of the losses).

In a certain abstract sense, the euro zone is suffering from exactly the same problem as the US. Each has collective institutions but its members are unwilling to accept that collective decisions involve both co-operation and sacrifices.

What is happening is that the global financial crisis (now being called the Great Recession) is exposing weaknesses in the political institutions. Which is perhaps not surprising, as those institutions helped create the crisis in the first place.