Recession Looms If Treasury Uses Tools to Prevent a Debt Default
By Rich Miller & Shobhana Chandra - Oct 9, 2013 12:00 AM ET
J. Scott Applewhite/AP Photo
If the government does avoid default, that wouldn’t mean the economy would escape a recession, said Michael Feroli, chief U.S. economist for JPMorgan Chase & Co. in New York.
The U.S. Treasury has the means to avoid a debt default even if Congress fails to raise the government’s $16.7 trillion borrowing limit. The bad news is that it can’t prevent a recession.
Oct. 9 (Bloomberg) -- Steven Major, global head of fixed-income research at HSBC Holdings Plc, talks about the impact of the U.S. partial shutdown on Treasury rates. He speaks with Francine Lacqua and Hans Nichols on Bloomberg Television's "On the Move." (Source: Bloomberg)
The Treasury typically takes in about $7 billion daily in income and payroll taxes, though those amounts can vary significantly from day to day, the Congressional Budget Office said in a Sept. 25 report. Photographer: Julia Schmalz/Bloomberg
“We are exploring all contingencies,” President Barack Obama told a press conference yesterday, when asked about the possibility of prioritizing payments to make sure the government meets its debt obligations. Photographer: Andrew Harrer/Bloomberg
Economists at Goldman Sachs Group Inc., IHS Inc. (IHS) and BNP Paribas SA said they expect the Treasury to husband the tax money it collects to make sure it can meet interest and principal payments on the nation’s debt. Other obligations, from salaries of government workers to payments to defense contractors, would face the ax. The result: $175 billion less ingovernment spending during November alone, said Goldman’sAlec Phillips in Washington.
“The cutting would be so huge it would put the U.S. back into recession,” said Jim O’Neill, former chairman of Goldman Sachs Asset Management who is now a Bloomberg View columnist.
Treasury Secretary Jacob J. Lew has said the “extraordinary measures” he uses to avoid breaching the debt limit will be exhausted no later than Oct. 17. He said the Treasury will then have about $30 billion on hand, while net expenditures can be as high as $60 billion on some days.
That would leave the government unable to pay all its bills. The Treasury typically takes in about $7 billion daily in income and payroll taxes, though those amounts can vary significantly from day to day, the Congressional Budget Office said in a Sept. 25 report.
Exploring Contingencies
“We are exploring all contingencies,” President Barack Obama told a press conference yesterday, when asked about the possibility of prioritizing payments to make sure the government meets its debt obligations.
He argued though that the country’s creditworthiness still would be damaged if it failed to pay some of its other bills as they came due.
The chances that the U.S. won’t raise its borrowing limit by the Oct. 17 deadline are “very low,” probably less than 5 percent, said Nariman Behravesh, chief economist for IHS in Lexington, Massachusetts. The costs of not doing so and defaulting are just too high.
“The financial ramifications would be horrific,” worse than what followed the 2008 collapse of Lehman Brothers Holdings Inc., he said. The U.S. stock market lost almost half its value in the five months following Lehman’s failure and the country plunged into its worst recession since the Great Depression.
Investor Reaction
Investors in financial markets are starting to take notice as the deadline approaches. The Standard & Poor’s 500 Index (SPX) slipped 1.2 percent to 1,655.45 at 4 p.m. in New York yesterday for its biggest drop since August.
Rates on Treasury bills due on Oct. 31 climbed to 0.34 percent from zero as recently as Sept. 19. That compares with a 0.11 percent rate for bills maturing on Oct. 10.
Lou Crandall, chief economist at Wrightson ICAP LLC, said the yields would be significantly higher if investors feared a genuine default. Instead, he said, what they’re concerned about is a deferred interest payment by the Treasury.
“Bill yields are close to zero for everything except stuff that might get caught up in the operational headaches of a delayed payment,” said Crandall, whose Jersey City, New Jersey-based company is a unit of ICAP Plc, the world’s largest broker of financial transactions between banks. “There is no default risk. There is a liquidity risk.”
Slump Certain
If the government does avoid default, that wouldn’t mean the economy would escape a recession, said Michael Feroli, chief U.S. economist for JPMorgan Chase & Co. in New York. He said a slump would be certain to follow if the choice is between a default or cutting other outlays to avoid one.
“In the first case, we’d have a recession and a financial crisis,” said Feroli, a former researcher at the Federal Reserve. “In the second case, we’d have a recession.”
Even if debt payments are made, the government would have to immediately eliminate its deficit and balance its budget because it wouldn’t be able to borrow more, Crandall said. The nonpartisan CBO has estimated that the deficit was $642 billion, or 4 percent of gross domestic product, for the year that ended on Sept. 30.
The threat of a sudden, large reduction in government outlays comes as the world’s largest economy is struggling to gain momentum. Growth in the first two quarters of 2013 averaged 1.8 percent, lower than the 2.2 percent average pace since the recovery began in June 2009.
“A 4 percent shock in a 2 percent-growth economy is very much recessionary,” said Michael Hanson, senior U.S. economist at Bank of America Corp. in New York.
Forecast Reduced
Consultant IHS already has reduced its forecast for economic growth in the fourth quarter to 1.6 percent from 2.2 percent to reflect a partial government shutdown that began on Oct. 1 after Congress failed to authorize government spending for the new fiscal year, said Behravesh.
Crandall and Phillips calculate that the Treasury will, for about a week after its Oct. 17 deadline, have enough money to meet the government’s obligations. After that, it becomes increasingly dicey, they said.
A $6 billion interest payment is due on Oct. 31, the day Crandall reckons the government will run out of cash. Bills totaling about $67 billion are due the following day, for Social Security benefits for retirees, Medicare payments to hospitals and other health-care providers, and military pay and benefits.
Interest Payments
Behravesh and Phillips expect the Treasury to do everything it can to avoid a default. “We do believe that the Treasury could ensure that enough cash was available to make interest payments on Treasury securities,” Phillips and his fellow Goldman economist Kris Dawsey wrote in an Oct. 5 report.
Net interest payments amounted to an estimated $223 billion in the fiscal year that ended Sept. 30, or less than $1 billion per day, based on CBO figures.
Interest payments could be facilitated because they are made separately from other government disbursements through Fedwire -- the Federal Reserve’s electronic network that allows financial institutions to electronically transfer funds among themselves, Phillips said.
“The federal government takes in more than enough revenue to pay the interest on its debt,” Brian Wesbury, chief economist at First Trust Portfolios LP in Wheaton, Illinois, wrote with colleagues in an Oct. 7 report. Federal receipts this month will total $200 billion, while interest owed on the debt will be $25 billion, they said.
Prioritizing ‘Unworkable’
Treasury officials have suggested that a strategy of segregating debt payments isn’t feasible. Lew said in a Sept. 17 speech in Washington that proposals for “prioritization,” or making some payments instead of others, are “unworkable.”
The Treasury makes more than 80 million payments per month and its systems are designed to make each payment in the order it comes due, Treasury Inspector General Eric Thorson said in an Aug. 24, 2012, report.
Some Republican lawmakers are skeptical of Lew’s argument that prioritization won’t work.
“The law requires the Treasury secretary to manage debt, the receipts and payments of the nation,” Representative Mick Mulvaney, a Republican from South Carolina, told Bloomberg Television yesterday. “We are a little worried that they are exaggerating for political advantage because most people up here think they do have the ability to prioritize.”
Spooking Investors
Investors still might be spooked even if debt payments are kept up, said Mark Zandi, chief economist at Moody’s Analytics Inc. in West Chester, Pennsylvania.
“If I were a bond investor and I saw Social Security payments not being made, I would wonder how long it would be before I wouldn’t be paid,” Zandi said.
Whether the Treasury defaults or not, “we’re in for a long, deep recession” without an increase in the borrowing limit, he said.
To make things worse, “it’s happening at a very sensitive time, right ahead of the holiday shopping season,” said Julia Coronado, chief economist for North America at BNP Paribas in New York.
If Social Security benefit payments are held up, “you’re talking about the immediate loss of a fairly significant chunk of income for a population that is fairly dependent on that cash flow,” she said. “You’d see an immediate pullback” in household spending.
The Fed would be hard-pressed to cushion the economy from such a budget squeeze, because it is already holding short-term interest rates near zero and buying $85 billion worth of debt securities per month to help bring long-term rates down.
“There is no way the Federal Reserve would be capable of offsetting” such a hit to the economy, said David Stockton, a senior fellow at the Peterson Institute for International Economics in Washington.
“Hitting the debt ceiling is going to have grave consequences for the U.S. economy, U.S. financial markets and global financial markets as well,” added Stockton, a former Fed official who is also a senior adviser to St. Louis-based Macroeconomic Advisers LLC.
“If I were a bond investor and I saw Social Security payments not being made, I would wonder how long it would be before I wouldn’t be paid,” Zandi said.
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