Posted by:
Andrew Bell

28 July 2011

In the US, the Boston Tea Party is viewed as a heroic protest by American colonists against the taxes imposed on tea by a British government in which they had no say. “No taxation without representation” was the cry, as the tea was dumped in the harbour and therefore no good either to the taxman or the consumer. In Britain, we think more of the Mad Hatter’s Tea Party from Alice in Wonderland and it is hard to be sure from which of the two the Tea Party in the US derives its heritage.

It seems bizarre that the US Congress can authorise future spending but subsequently have to vote on whether to permit the necessary borrowing to fund the agreed budget deficit. It seems surreal that a Republican Presidential contender (oxymoronically described as the thinking person’s Sarah Palin) can say that she will oppose raising the permitted debt ceiling when it will be reached within a week and the approved Federal budget is in deficit to the tune of some 9% of GDP this year - $25bn per week.

It is barely credible that the world’s largest creditor with a hitherto AAA credit rating is at risk of voluntarily closing down its government or defaulting on interest payments because the two parties cannot agree on a mix of spending cuts and tax increases to begin to restore the US budget finances. Politics may be a game when it is posturing for electoral advantage over issues which are unimportant but statesmanship is meant to kick in when the issues are so important that the public interest trumps narrow party advantage.

The implication of not raising the debt ceiling to accommodate a legally approved budget is that any spending in excess of day to day tax revenues raised will stop. Ways that this could be implemented include stopping the pay of public servants, politicians or the army, cutting back government purchases or failing to meet interest payments. The amounts of public spending to be cut for the government to operate in surplus are not trivial – over $1,000bn, or a third of the annual budgeted spending.

Such a dramatic fiscal tightening (an annualised 9% of GDP overnight) would immediately plunge the US, and no doubt most of the world, economy into recession. If there were a failure to make (or a delay in) interest payments on US Treasury bonds, which are viewed as the “risk-free” foundation to the markets’ entire pricing structure for riskier assets, the implications for financial markets would also be extremely severe – a rapid US descent from AAA to AAArgghh.

It is because the implications are so severe that it is so puzzling that politicians do not as a matter of course raise the debt limit (which is an enabling mechanism to accommodate past decisions) then get on with the debate over how to narrow the deficit in future. The debt ceiling is not needed as a crowbar to force a responsible budget deal – European governments have seen that markets are capable of exerting pressure on countries which lose fiscal credibility.

The severe consequences of the path being pursued undermine the belief that it could happen. Unfortunately, the US may be solvent but its politics are not sober. A misjudged game of chicken could lead to a car crash, even if the severe market and political consequences rapidly forced a reversal. This is what is enabling financial markets to view the possible calamity calmly. Everyone believes a deal will be done to avert a default and government shutdown. Hence bond yields are low and equities range-bound. People want to be invested for a post-deal bounce. Yet without some market volatility those in Congress who have an Alice in Wonderland view of the world will not see sense.

It seems likely that, through some tortuous process in coming weeks, the US will raise its debt ceiling and take limited steps towards reducing its budget deficit. Provided that the preceding shenanigans (together with the recent European fiasco) has not unduly damaged economic confidence, this would allow equity markets to shift attention to the prospects for earnings and shed their anxiety about recent macro-economic events.

Short-term binary events are less important for investors than for traders but the ignorant nature of the US fiscal debate means one cannot totally rule out someone pressing the auto-destruct button. The stories this spring about a decline in the UK population of cuckoos now have an explanation – mass migration to Capitol Hill. 

Comments or feedback are always welcome at theblog@witan.co.uk

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