The US Budget Crisis: How Great Are the Risks?

Until September, the only thing worrying global investors was the Federal Reserve’s decision to change monetary policy. But although everyone was pleasantly surprised by Bernanke’s decision not to change the tempo of the increase in the Fed’s balance sheet, it seemed like a very short-term solution for the markets. The fact of the situation is that it is possible that the Fed had to abandon its plans due to the rising political tension around state finances. Because it did not pose a great threat in September, the process of agreeing on the budget for the 2013-14 fiscal year and the debate on the debt ceiling became factors that have paralyzed the movement of markets in the last few weeks.

The first risk is related to the fact that Congress has not passed a law on the budget of government programs, thereby stopping their funding from Oct. 1. The staff members of a number of public services in the U.S. have been sent on forced leave. This situation will continue until the Republicans manage to come to an agreement with the Democrats on a new budget. This could potentially hit the fledgling American recovery — according to first estimates, freezing funding could cost the U.S. from 0.1 percent to 0.4 percent of its gross domestic product in the last quarter of the year. Some experts, extrapolating the situation into 2015, predict that a new round of recession may even creep in.

The negative economic forecasts are becoming more and more likely as the budget discussion deepens a long, complicated situation. The U.S. is standing on the border of a technical default. If the government has not reached an agreement with Congress by Oct. 17 on the question of raising the debt ceiling, then a freezing of debt repayments will have to be added to the freezing of running costs. A technical default has happened only once before in U.S. history, in 1979, which caused a jump in rates by 0.6 percent. A technical default will create a significant shortage of liquidity in American and global financial systems, which will become a great hit to the American economy. At the moment, in addition to the technical default option the government is spending more time discussing a soft scenario, in which only a percentage of repayments will be frozen. This could smooth the reaction of the markets, but not completely erase the negative influence. We should have clarity on the issue of whether the debt ceiling should be raised from the current $16.7 trillion by Oct. 17.

Aside from the negative consequences on the economy and market, the unavoidability of a harsh discussion on the budget situation in the U.S. is quite clear. Any further increase in the national debt will mean that the U.S. government will become more dependent on foreign creditors and on the Fed, which in the future will put additional pressure on the budget in the form of a rising percentage of debt as part of total spending. On the other hand, the only way to stabilize the ratio of public debt to GDP would be to accelerate the pace of economic growth and this, apparently, would require budgetary support while the private sector is not strong enough. However severe the problems of government debt are, it is clear that now is not the best time to tighten up fiscal policy. Aside from this, the total U.S. national debt is only 106 percent of GDP and federal budget debt only 73 percent, despite the fact that in Japan it is over 200 percent of GDP. Therefore, the potential to raise the debt ceiling is clearly an option.

It is for this reason that the financial markets, although they are tense, are not taking the developments in the budget discussion as seriously as they took the Fed’s summer hints that it might tighten monetary policy. There are several factors to take into consideration: Firstly, the reserve currency status allows the U.S. a minimum of negative consequences as a result of the political arguments that are occurring. The absence of alternative debt markets will continue to provide the inflow of international capital in the market of U.S. debt. Secondly, in the case of technical default we cannot doubt that the Fed will be forced to refuse the support of the financial markets; that is, instead of tightening it will soften monetary policy. These two considerations and hope for the reluctance of the American leadership to undermine the status of a superpower point toward a favorable outcome for the U.S.