A 'non-trivial' risk of a US debt default
Updated: Apr 24
It is said that 'the road to hell is paved with good intentions', and this potential political and banking policy accident is a great example of why that happens.
Photo by Gabriel Meinert on Unsplash
JP Morgan has said there is a ‘non-trivial risk’ of a US debt default this summer. We agree. In fact, they may be under-stating the risk. Analysts at blue chip banks are somewhat restricted in how far from the consensus they can stray, and so their restraint may not be voluntary.
Simultaneously, we also agree with Dennis Shen, ratings analyst, in his London School of Economics blog, when he says, “there is no debt crisis in the United States other than one of its own making.”
And so we have the boundaries of the problem: it is a political problem, not a fiscal one.
The political impasse is an old one: fiscal conservatives (often Republicans in contemporary history) control Congress, and want limitations on fiscal spending as a condition for increasing the debt ceiling. The Democrats who control the Senate and the Executive branch (the Presidency), argue that the fiscal spending has already been passed by Congress (prior to the new term when the Republicans took control).
As Shen points out, it was a similar stand-off that led to a technical default in 1979, another contentious period, when the world was plagued by inflation, banking crisis and a Cold War.
Moral Hazard 2.0
The difference between today and the past, is that this debate is taking place in a new paradigm of global banking. Since the Great Financial Crisis, central banks have taken on new and near omnipotent powers.
In his book, Road to Ruin, libertarian Jim Rickards explains the vast powers in some detail. These new powers are more evident when they are wielded during each of the banking rescues we have witnessed over the past decades, from Cyprus to those most recently in the US.
However, there are consequences that come with new powers. Where libertarians are often right is in the view that top down control rarely results in the intended consequences. Rather the players of the game adapt and act differently based upon the new rules.
Is it plausible then that politicians will behave differently during this debt ceiling negotiation, in comparison to past negotiations?
New rules, new game
When the rules change, the game changes. So it is at this juncture that our views differ from more conventional analysts.
In an attempt to make the world safer, we endowed central banks with more power. However, the risk is that this permits politicians to be less responsible.
In their article, Axios references a 2013 discussion at the Federal Reserve (the US central bank) on the issue of the debt ceiling. A certain Mr Jerome Powell, when pressed by then Chair Ben Bernanke on his responses to a ‘debt ceiling crisis’, conceded that he would take ‘loathsome actions’ to prevent the worst outcomes. The full 50 page discussion between Fed officials is here.
And so there we have it. The current Chairman of the Federal Reserve, on record stating that he won’t let the worst outcomes take place under his watch. In light of this, his repeated statements over the past year, that the debt ceiling is a matter for politicians must be seen as a bluff.
However, is it plausible that this time around, the politicians will the assume the Fed will underwrite the risk, with their new powers?
And if the politicians know that the Federal Reserve is bluffing and so will act (to rescue the economy), then what incentive do they have to act responsibly. And so we see how changing the rules of a game, can change incentives and induce errant behaviour. The road to hell is indeed paved with good intentions.
To be clear, the market's consensus remains that the politicians, after their Maori-style political Haka, will eventually reach a settlement (as that is what they usually do).
However, more and more analysts are cautioning against more alarming outcomes. After all, complacent markets are often the most fertile gardens for vivid (price) volatility.
What are the implications for litigators?
We are banking and finance experts who write for litigators (though we hope this is helpful to others too).
The direct implications of a default aren't serious. Were the US to technically default on debt, it will likely all be done legally, and if it weren’t they could even back date and grandfather laws to achieve their goals. Like the present litigation against Swiss regulators in relation to Credit Suisse, we are cautious about actions against central banks and banking authorities in the post-2008 world.
That said, given the numerous indirect consequences. This new environment is likely to lead to volatility, in both directions. Volatility often results in losses, and that is good for litigators: that is because litigation is a function of losses and opacity (of contract).
As Barrons says, "the likelihood of an accident in the so-called shadow banking system will also raise the economic temperature. These shadow banks, which include hedge funds, equity funds, insurance companies, and pension funds, now intermediate more credit than the traditional banking system. They are also known to be both lightly regulated and highly leveraged." We agree with that too.
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Reference links:
Dennis Shen blog on LSE
A Hot Economic Summer is shaping up (Barrons):
https://www.barrons.com/articles/economy-federal-reserve-politics-debt-ceiling-9936779e?mod=hp_LEAD_1_B_4
JP Morgan sees ‘non-trivial risk’ of US technical default (Reuters):
Axios summary article of Fed debt debate:
https://www.axios.com/2023/04/19/fed-debt-ceiling-default-playbook
The Fed’s 2013 debate on the ‘Debt Ceiling Problem’
https://www.federalreserve.gov/monetarypolicy/files/FOMC20131016confcall.pdf