The news has recently been dominated by one major story; the USA federal government shutdown.
What is the shutdown?
The shutdown is another result of the political turmoil that is occurring in the federal government (see previous blog on fiscal cliff). Barack Obama, Democrat, holds the presidential office, but the Republicans hold the House of Representatives. Over the past couple weeks it has been the responsibility of the House of Congress (comprised of House of Representatives and the Senate, the latter Democratic controlled) to pass the budget for the next financial year; this budget indicates how much the federal government has to/can spend. However due to conflicts in interest between the Republicans and Democrats there has been a stalemate and the House of Commons have not passed the next budget. This means that the Federal Government is not authorised to spend anything until another budget is agreed, leading to a lockdown of Government services.
Is this harmful?
Financial markets: The financial markets have been rather muted over the Shutdown, this is because past performance has indicated that a Government shutdown tends not to affect stockmarkets. There have been 17 government shutdowns since 1977 and technical analysis shows that there has only been a 2% fall in US stocks after 7 days of shutdown.
Tourists: The shutdown heavily affects the tourist industry, as major sites such as the Lincoln Memorial and the Smithsonian’s are closed as there is no finance to maintain their upkeep. Furthermore foreign workers are anxious as the office for visas is not currently running – meaning their legitimacy to work and live in the USA is compromised.
Financially: The shutdown will have large financial implications. Although the Government isn’t spending any money during the shutdown, the costs of the shutdown could be rather substantial. An article by the NYTimes states that during the two most recent shutdowns (1995 & 1996) the cost to the treasury was the equivalent of $2.1 billion in today’s money. This is due to backlogs of wages, when government employees return to work, and also the reduction in productivity as the employees have to siphon through all the paperwork that has built up over the shutdown (incl. passport applications, benefit claims, visa renewals etc).
However, I don’t think that the shutdown is the real issue here, the real problem emerging from this will be the Debt ceiling, which needs to be resolved by the 17th of October.
What is ‘The Debt Ceiling’?
The debt ceiling puts a limit on the amount of money that the federal government is allowed to borrow. With the recent stalemate, arguments over the budget and consequentially the resulting shutdown there has been some nervousness surfacing in market investors – who are worried that an agreement over the debt ceiling will not be reached. If there is no agreement the US Government will have to default on some of it’s debts. This would be climactic, infact I would go as far as to say it would have a more profound effect on the world economy then the Lehman’s Collapse.
If the US government has to default on some of it’s debt it would lead to a sell-off of Treasury Bonds (T-Bonds). The sell-off will reduce the T-bond’s price, thus increasing their yield; then things become nasty. A lot of financial instruments around the world are tied to the T-Bond, using their yield as a benchmark for setting interest rates. If the T-Bond yield rises this would cause a knock-on effect on increasing interest rates worldwide. This means, even without official central bank changes, the cost of mortgages would rise, shares would be revalued at a higher real rate of interest (resulting in a fall) and all this would hit a quite vulnerable global economy pretty hard. To make matters worse the financial markets won’t be aware of which T-Bonds the government is defaulting on for a good 1-2 days after the US government defaults. This will help spur a massive sell-off of all US Government debt.
At the moment the general market consensus is that there is a 20% chance of default. Some investors are smugly confident that the US Government will not default because, frankly, the Government would have to be utterly crazy to reach that conclusion. Still it will be interesting to see how the market begins to react on Monday, I suspect shares won’t fair very well over the coming week as they begin to factor in the risks of default; but I doubt, and very much hope, that a default does not occur. It would certainly ease everyone’s minds if the shutdown ceases before the debt ceiling deadline on the 17th.
Let me know your thoughts or questions @Breadeconomics or leave a comment below.