Research & Commentary

US default – could it really happen?

One hundred years ago, as the First World War was raging in 1917, the US Congress approved the Second Liberty Loan Act, in which it modified the method of approving new government debt issuance. In order to provide more flexibility for the government after the country became involved in the war, Congress established an aggregate limit, or ceiling, on the total amount of new bonds that could be issued. The US “debt ceiling” was born.

Since then, there have been a number of occasions when the debt ceiling has come under the spotlight, the most recent being in 1995, 2011 and 2013, when the unthinkable (to most) prospect of the United States of America defaulting on its debt was raised. There are economists who take the view that it is impossible for the US (or any government) to default on their debt because they would just print the money to pay what they owe. This may make sense from an academic, ivory tower perspective but, in the real world, it doesn’t work like that. A default is a default.

It is important to note that the present debt ceiling does not limit the government’s ability to run budget deficits. What it means is that, once the aggregate ceiling is reached, it is a limit on the ability to pay (interest and capital repayment) on obligations already incurred. When this appears likely, politicians will argue about increasing the ceiling, and guess what? That’s what usually happens. The can is punted down the road.

But now the gargantuan US government debt is back in focus with speculation mounting as to when the next debt ceiling crisis will reach a crisis point. After the defeat of the Health Care reforms in July, worries have increased that Congress will not be able to unite in order to reach a budget deal. If no deal can be reached, according to a Bloomberg article from 6 July, the first week in October is the most likely time that a default may occur. The article  states:

“Depending on the pace of tax revenue over the next few months, the date may change by several days, but not likely as much as a week. The largest issues in early October are $24 billion of Social Security payments and $6 billion of federal employee retirement payments due at the beginning of each month”.

The government has been servicing its debt using so-called “extraordinary measures” which give them a stay-of-execution before (they hope) the debt ceiling is raised. Unless the ceiling is raised, it looks like their available funds will run dry in early October. The Congressional Budget Office and the Bipartisan Policy Center both agree that early to mid-October is the time that the money finally runs out.

The Treasury Bill yield curve shows that concern is being priced in, with a big gap between the T-Bill maturing on 21 September and the T-Bill maturing on 19 October. T-Bill yields subsequently drop further out the curve. This means that, although fears of a US default have risen, the market still believes that a budget deal will be reached – some speculate that the disaster wrought by Hurricane Harvey will bring parties together to reach a deal for the good of the nation. At this stage though, nerves remain.

The early-to-mid-October timing will delight stock market bears, of course, because September and October have historically been the months when the most dramatic crashes have occurred. Would a US government default cause a stock market crash? We prefer to think in terms of socionomics and Elliott waves, and so if the “unthinkable” happens, the warning signs will appear in stock market price data before any event occurs.   

We have been here before. The most likely outcome is that the debt ceiling is raised and the government, as they always do, will keep their Ponzi scheme going for now. Sometimes though, moments occur that make history. As the writer Junot Díaz said, “it’s never the changes we want that change everything.”

 

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