Whilst most eyes are fixed upon the possibility of a Greek default at the moment, the possibility of a far more serious default is looming. The Federal government in America is scheduled to hit its borrowing limit – the maximum that Congress allows the government to borrow – this summer. It is possible that Congress will allow the limit to be raised, but the political strings attached seem to be causing political gridlock in Washington at the moment. Congress has tied the increase in the borrowing limit to a deficit reduction plan. There is no real consensus at to whether tax increases or spending cuts should form the prime feature of the deficit reduction plan, and lines are drawn broadly on party lines.
The interesting question is what happens if America defaults? It should be noted that in terms of sovereign debt, a default occurs when an interest payment is one day late. It appears that a major interest payment is due on August 15th and the CDS markets are pricing in a default. Volumes of CDS trades have increased dramatically over the past couple of weeks and the one year CDS spread is now priced in similar terms to the five year spread. This does not augur well.
Evidence suggests that if the US does default, then US Treasuries could be subject to an additional risk premium of about 60 basis Points (i.e. of 0.6% per annum). This doesn’t sound much, but it is an additional cost of $86 billion a year to the Federal exchequer. To put this into perspective, it’s roughly the size of the Federal spend on pre-primary to secondary education in 2011. The cost of gridlock in Washington roughly equates to the Federal education budget.
I find it hard to believe that an advanced society will allow such political brinkmanship. If there ever was a case for the institutions of a New Enlightenment, then this is it!
© The European Futures Observatory 2011