US Debt Crisis: Is It Different This Time?

Economic history is a poor adviser as far as predictions are concerned. Although the same factors may be in play today, the budgetary crisis of 2013 could well not resemble that of 2011.

The initial context is very different in that it deals with an external environment of growth and economic policy.

First, the external context: The summer of 2011 was marked by the intensification of the European crisis. Doubts about the longevity of the institutional assembly of the Eurozone and the crisis of bank liquidity — after the massive withdrawal of U.S. monetary funds — made the U.S. a place of refuge by default, for its money and treasury bonds.

The monetary context was itself also rather different. Some weeks ago, the Federal Reserve decided to maintain its purchases of Treasury bonds — and paper-backed mortgage debt — in foresight of budgetary turbulence. At the end of June 2011, it had put an end to its purchasing program, QE2, and discussed some methods for the next stage: the “twist” operation, which consisted of selling the papers in the short term to buy the public debt a longer expiry date.

Economic activity presented equivalent signs of weakness during the summer of 2011. Today, this activity is accelerating, as indicated by the directors of sales of ISM Manufacturing.

In 2011, the opposition between Democrats and Republicans hinged essentially on the method of reducing the deficit and slowing down the fast progression of the public debt. Today, the deficit has been highly reduced — a cyclic effect, which means that the imbalances have not been resolved in the long term and the opposition is much more ideological than economic — [they want] to get “Obamacare” out of the way rather than improve the sustainability of the public debt in the long term.

While reading these indicators, the situation seems far more favorable today. Europe is showing (weak) signs of recovery. The Fed’s monetary policy is accommodating. Growth seems more robust: It has risen by 1.6 percent in a year to the second trimester of 2013, a more than respectable performance given the harsh budgetary cuts this year.

This could explain the relative complacency of the financial markets. The S&P 500 clocks in at hardly 3 percent, short of its highest in history. In particular, volatility is very weak, far from the levels of 2011 and those the political risk index of Baker, Bloom and Davis suggests.

In the absence of clear signals on the topic of negotiations between Republicans and Democrats, and while the deadline for raising the debt ceiling is approaching again — after Oct. 17, the Treasury will no longer be able to borrow to refinance its obligations before the due date and pay its expenses; of course, there could be a priority distribution of expenditures, but only for a few days — we can make out three types of attitudes:

– Complacency: A last minute agreement will be found, and everything will return to order. Stocks may go down after some time, offering purchasing opportunities when things are better. It is clear that the few weeks of “shutdown” will weigh on activity, but the several tens of points of growth lost will be recovered in the fourth trimester. This approach is based notably on the too-hasty analysis of the previous “shutdown,” which occurred under Clinton from 1995-96.

– Simplicity: There is evidently a risk of worsening the crisis as the Oct. 17 deadline approaches. During this period, we should see a reduction in market activity but also, in the same way as in 2011, a strengthening of the dollar and a reduction in interest rates. The greatest lesson from 2011 is that despite the loss of its AAA rating from Standard & Poor, the U.S. remained a refuge. The Fed remaining accommodating could come to support this theory, but we forget that Europe is not enduring any sort of major tension today and also, particularly, that the sequestration allowed for everyone to hold their heads high in 2011. I hardly see how today, given the ideological character of the opposition, we can refabricate a similar “rig” to the sequester to come to an agreement on a debt ceiling.

– Suspicion: to be wary of the past, whether recent or distant. 2013 is far from presenting major similarities to 2011. The risk of no compromise is much more important than the current level of the political risk index suggests. Moreover, the economic policy environment — the Fed has postponed and not abandoned its reduction in purchases of public notes — and the exterior (we hear of no crisis in Europe, no major tension) renders the theory of the U.S. as an ultimate value refuge much less attractive. Moreover, the graphics below show that the correlation between the dollar, the S&P 500, and the interest rate in 10 years has experienced a marked change over the course of the last months. The triptych of a strong dollar, lower interest rate and activity in decline is far from evidence in the case of a worsening crisis.

History is a poor adviser on the economy. It is even worse when political uncertainty transplants itself onto economic risk. Without a doubt, the crisis of 2011 allows us to analyze today’s, but nothing indicates that the implications will be the same. In particular, the reaction to the dollar and American bond yields could be very surprising.