The Debt Ceiling Drama
The debt ceiling is exercising the minds of anyone who has an interest in the continued functioning of a key plank of the financial system. It relates to part of the system that underpins our capitalist economy. US Government debt.
Many conspiracy theories surround the attribution of the US dollar as the most powerful currency on earth. Being the world’s reserve currency is important. However, it is nowhere near as important to the US and world economy as the US Government meeting its commitments by raising the debt ceiling.
Normally, it makes no sense to compare government debt with business or household debt. A government lives on in perpetuity and as long as it managed its debt properly, there is no reason for it to be avoided or even paid down.
Further, while an economy is growing over the long run, the amount of debt the government will accrue will also grow over the long run. The amount of debt outstanding should grow on average.
If we impose a limit on the amount of government debt, then the government behaves like a normal household and business. Cash, which has become scarce because they cannot borrow it, will have to be rationed out.
Should they pay the bondholders first and stop paying soldiers and pensioners in order to keep under the debt ceiling or the other way around? These are the decisions that the government will have to make and the big loser will be the financial system.
Does It Matter?
‘Who cares’, you may say, ‘I’m not a pensioner or a soldier and I don’t own any bonds’. If that is your attitude to the debt ceiling, you’re missing the point. US Government debt is like the engine oil that the world economy runs on.
The interest rate on US Government debt is a critical ingredient for the pricing of risky assets. They need a risk-free asset to provide the basis of comparison. Be prepared for the share market to take a big nose dive if they don’t raise the debt ceiling in time.
In Australia, the typical superannuation fund comprises ownership of shares and bonds. The values of these funds will plummet.
Businesses will face insolvency. Rationed capital will be difficult to get hold of and the cost of those borrowings will go up as the ultimate source of borrowings dries up.
Unemployment will jump radically as it did in the Global Financial Crises.
Although it won’t be like the Covid pandemic, where businesses were closed as a policy decision, the disruption will occur just as suddenly.
Recession?
Many recessions are self-imposed as a method of combatting inflation, or because of being blindsided. This one would be gratuitous. It will befall the world economy because of a game of bluff bought about by one house of Congress. It will be like the Covid Pandemic at the speed at which it will affect the world economy.
While there are unconventional methods of overcoming the debt ceiling, they have a whiff of tin pot finances strongly attached to them. They are also likely to have a temporary effect.
Using our earlier analogy of engine oil. The damage that the current economic architecture would suffer would be more like a seized motor than running out of petrol. It would drive fundamental changes to economic behavioural psychology. Participants would forever consider the possibility that the US will default on its debt.
The ability to park your money in a risk-free asset is a crucial platform for investing it in productive but risky assets. What measure of return will guide your decision to invest?
The reasons that not raising the debt ceiling are terrible fall into what many will think of as theoretical. They have to do with the functioning of capital markets. Unfortunately, these theoretical reasons will find practical outcomes quickly. They will include failing businesses, unemployment and ultimately great hardship falling on households.
This will happen at a time when the stock of resources we can draw on to throw at new disruptions in the national and world economy is exhausted. Debt levels in the private and government sectors are at historic highs because of the recent battles with the Covid Pandemic. If there is a default in the most important engine of debt in the world, it will be hard to raise money to fix things.
It would throw us into a deflationary world where the recent rise in interest rates would head back towards zero. Before you jump for joy at this, consider that zero rates will still be too high and we could never lower them enough to get us out of trouble.
Self-Inflicted
All of this would be gratuitous. Bought about by intransigence and partisanship that cannot decide for the common good and is unwilling to raise the debt ceiling.
The story of the world economy since the Global Financial Crises has been one of the imbalances bought about by the need to avoid chronic recession.
We bought interest rates to historic lows, leading to speculation in assets that have left a generation of Australians out of the ability to buy a house. It has widened the gap between the haves and have-nots in our society and reduced the middle class in Australia.
A vibrant middle class is the ultimate bulwark of a society and an economy. It is the stepping stone that provides us with a way out of poverty to relative comfort.
The magnitude of this problem is written about by many economists. This one in the New York Times highlights how time is running out for a solution.
More of My Articles
As a prolific writer, I enjoy creating online content. Regular writing means new content frequently. Take this chance to read some of my other writings such as “The Budget 2023 – Based on Luck” and “The Reserve Bank of Australia Set up to Fail“.
Not only can you find my writings here on this site but also on my Business Broking Site called “Hunting Business Sales and Valuations“. In particular, read my article on “When is the best time to sell a Business” and you will see the relation to this article.
