Financial Markets Are Not Expecting a U.S. Default
Scott Applewhite)
Financial Markets Are Not Expecting a U.S. Default
Scott Applewhite)
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Is it possible for the United States, the issuer of the world’s reserve currency, to default? Financial markets don’t seem to think so. Default rhetoric is nothing new and the US has always managed to raise the debt ceiling in time (some 80 times since 1960) to avoid the worst-case scenario. Why should this year be any different?

Yet, with US federal debt within a hair of the $28.4 trillion debt ceiling (Chart 1), and the cash balance of US Treasury at the Federal Reserve rapidly dwindling (Chart 2), Janet Yellen warned last week that, unless Congress acted soon, the US would be on course to default on October 18. 

Is the market right to think the latest default talk is just a lot of hot air? In my view, there are good reasons to think that even if the US were to avoid default, the new round of fiscal brinksmanship that begins in earnest this week may have a greater impact on the economy and on markets than generally expected. Indeed, I see it as looking more like 2011 than 2017.

Let me explain why. 

Let’s begin by defining brinksmanship. In game theory, brinksmanship is called “the Game of Chicken.” The best-known example of this game appears in an unforgettable scene in the movie “Rebel without a Cause” where Jim (played by James Dean) and Buzz dare each other to race their cars to the edge of a cliff. Whoever jumped out of his car at the last minute would be, of course, the chicken (or loser).  

Another, more typical, illustration of this Game of Chicken is that of two cars speeding towards each other head on. How will it end? With a terrific crash killing both drivers? Or will one of the players swerve at the last minute?  

A key concept in game theory is the Nash equilibrium, named after John Nash, (a mathematician memorably played by Russell Crowe in the film “A Beautiful Mind”) which says that the most optimal outcome of any game is one in which each player makes the best decision for himself based on what he thinks the other side will do. It turns out that in the Nash equilibrium of the Game of Chicken, one of the players will swerve just before the crash. However, it is impossible to know at which stage of the game this will happen. Ironically, the more each player views the other player as being rational (in this case, not wishing to die), the longer the player will hold out (expecting the other player to swerve first). This is what makes the game of chicken so incredibly tense and scary.

So, what is fiscal brinksmanship? For the purpose of this article, I am referring to the negotiations between the Democratic Party and the Republican Party whereby the cost of not reaching an agreement is government default.  

Below are the basic parameters of the Game of Chicken being played out in Washington right now:  

The Democrats’ objective: To pass the $3.5 trillion social spending bill (that would represent the biggest expansion of the American welfare system in recent memory). 

The Democrats’ leverage:
 (1) They have a majority in the House of Representatives; (2) Even though the Democrats control only half of the Senate seats, they have an effective majority given that the Constitution allows the Vice President to vote to break a tie; (3) The so-called “reconciliation process” allows the Senate Democrats to pass the reconciliation bill with just a simple majority.

The Republicans’ objective:  To stop the passage of the $3.5 trillion social spending bill. 

The Republicans’ leverage: Not much. The only leverage they have is the threat to withhold their votes for raising the debt ceiling.

Two weeks away from the US Treasury running out of cash, the Republicans are using this leverage.

This leaves the Democrats with two options: 

Option 1: Dare the Republicans to follow through with their threat.

Option 2: Get around the Republicans by using reconciliation to raise the debt ceiling.

Which of these options will the Democrats exercise?  

Option 1 has one little problem: Joe Biden. Biden’s approval rating has fallen so much over the past two months that he is now doing worse than 9 of the last 10 sitting presidents in the September of their first year in office (Chart 3). This means that if a showdown with the Republicans was to bring on a real crisis, voters are more likely to blame the President and the President’s party. This makes Option 1 a risky strategy for the Democrats. 

Option 2 also has a little flaw: reconciliation can only be used once a year. This means that unless the Democrats are willing to give up on their $3.5 trillion social spending bill, they will have to include the debt ceiling in the reconciliation bill for social spending.  

The latter seems to be the safest option for the Democrats except for the fact that it requires party unity over the $3.5trn social spending plan that simply is not there. Indeed, the progressive wing of the Democratic Party and the centrists are at war over the size of the social spending bill. While the progressives view $3.5trn as already a slimming down of the Democrats’ campaign promises, the centrists are concerned about the impact on debt sustainability and long-term economic growth.

There is so much bad blood between the progressives and the centrists that they have been engaging in a Game of Chicken of their own. The progressives will not vote for the $1.2trn bi-partisan infrastructure bill that the centrists support unless the centrists agree on the $3.5trn price tag for the social spending bill. As a result, the vote on the infrastructure bill has already been twice delayed. 

The fact that there are two Games of Chicken being played at the same time is what makes the outcome of the forthcoming debt ceiling negotiation highly unpredictable. The only way to avoid going to the brink is if the progressives and the centrists in the Democratic party compromise. However, the gap between the $3.5trn demanded by the progressives and the $1.5trn that Joe Manchin says he can live with is so wide that I would not put my money on a deal before October 18.  

The upcoming debt ceiling crisis will weigh on the economy and the stock market. It will also strengthen the call for the abolition of the debt ceiling in many quarters. In my opinion, the debt ceiling is a necessary evil for the United States. The status of the US as the issuer of the world’s reserve currency means that market discipline that keeps lesser countries fiscally in line does not apply. Both the Democrats and Republicans talk about fiscal responsibility when they are in opposition, but they seldom deliver when they come into power. Therefore, the institution of the debt ceiling, as inconvenient as it is, has an important role to play to keep fiscal insanity in check.

David Woo is the founder and CEO of David Woo Unbound, a new global forum devoted to fact-based debates about our shared future. David was previously the Head of Global Rates, FX, and EM strategy & Economic Research at Bank of America.

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