US politicians will have to raise the debt ceiling again on 15 December to avert the first ever default on US obligations. A so-called “default” puts at risk payment obligations such as interest on debt. Investors are getting very nervous about this.
The US has a debt problem. US Treasury Secretary Janet Yellen warned earlier this month that the US could default on December 15 if politicians do not act on the debt ceiling. The most pressing obligations are related to the $118 billion allocated to the new infrastructure bill. With the colossal transfer to the Highway Trust Fund, the US risks running out of money in the treasury.
“Many do not understand the full impact of a transfer. Default would likely cause a financial crisis and recession”, reported Cecilia Rouse, chair of the White House Council of Economic Advisers. Unless Congress authorises an increase, the US cannot take on additional debt. In that case, payment obligations such as paying benefits and interest on debt would be at risk.
Investors want clarity
“Especially the latter makes investors very nervous,” said Ivo Arnold, professor of monetary economics at Erasmus University and Nyenrode Business University. A similar tense situation arose in 2011. At the time, Congress narrowly averted a crisis by raising the ceiling at the last minute.
“This self-imposed discipline says nothing about the ability of the US to pay off debts. If they decide to violate this deadline, they are shooting themselves in the foot. If they can’t issue more debt, they will have to cut spending like benefits or reduce interest payments on government debt,” Arnold said.
So far, the US Congress has always raised the ceiling at the last minute. According to Arnold, it is in nobody’s interest not to reach an agreement. “If benefits have to be cut, the American electorate will be dissatisfied and if interest rates on debt are lowered, investors will be anxious. Uncertainty may arise.”
“That tension is the first thing we see in the spreads of the short US government bonds. The question of whether they will be paid is not the biggest problem, it’s about the timing. A capital market wants clarity on that,’ Arnold said. “If the US government can no longer spend money on many people in America who depend on that spending (benefits, defence, healthcare) then they will be in trouble and that could cause a blow to the real US economy. That blow will be felt in the global economy and it is in nobody’s interest to deal such a blow to the American economy.”
Maximum debt
While the eurozone has a debt ceiling of 60 per cent, as laid down in the Stability and Growth Pact, the US has a unique concept that specifies an amount. No other modern economy has such a nominally-quantified maximum debt.
According to Professor Arnold, a maximum debt expressed in an absolute amount does not say much about whether too much debt has been incurred. “If you want to set standards for government debt, it is strange to express it in absolute amounts”, he said. “In that situation you can hardly avoid raising the ceiling from time to time, simply because the economy is growing.”
The debt ratio - the debt in relation to GDP expressed as percentage – is not excessively high in the case of America, according to Arnold. “The effective sustainability of the debt is in fact not an issue, inflation is the pressing issue. That is much more important than the debt limit.”
Inflation is more important than the debt ceiling
According to Arnold, the key question is to what extent inflation is temporary. “There are a multitude of influences that have an impact on inflation. Initially I thought the problems would solve themselves more quickly.”
The infrastructure package in question is part of the US government’s strategy to keep spending up. The question is to what extent it will succeed in boosting spending. “You see inflation rising faster in America than in Europe, so inflation is more of a concern than a debt ceiling.” Arnold calls the debt ceiling a political toy of the opposition to thwart the governing party at all times. According to him, it is a way to steer political negotiations.
The Democrats’ narrow majority in Congress means that it will be tense again. With tight political majorities, a debt ceiling becomes more meaningful. According to the professor, this time it is again about political pressure, not about the sustainability of the US national debt.
“Not finding a compromise, and thus not raising the debt ceiling, is an irresponsible experiment. I predict they will find a compromise at the last minute. The closer we get to that deadline, the more tension there will be. We will see that in the spreads,” Arnold concluded.
Financial institutions like Rabobank, but also Amundi and Pimco, see the risk of long-term global inflation, but also the threat of political unrest in the US, as a reason to reduce their exposure to government bonds in the fixed-income part of their client’s portfolios.