Tuesday, 28 June 2011

An American Default?

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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!

http://www.economist.com/node/18866851

© The European Futures Observatory 2011

2 comments:

josh wilcoxson said...

-As the interest payments are only a small percentage of our budget (<5%), some people feel that there is no real threat of default, even if the debt ceiling is not raised. Do your projections show otherwise?

-Just to clarify for the non-US readers, public education in the US is funded almost entirely by state and local taxes, in the form of property tax and VAT. The federal contribution may do more harm than good in that it is tied to national standards that hurt the nurturing of creative skills.

Stephen Aguilar-Millan said...

Dear Josh,

To answer your question, I'm afraid that it's yes and no. The interest payments are a low percentage of the total amount, but it is the perception of a default that is important.

We saw this last week in the case of France. France is quite sound as a Eurozone nation, but the perception of France as a nation in trouble led to a run on it's sovereign debt.

If a run on the sovereign debt is allowed to take hold, then it is quite easy to move into a self-fulfilling vicious circle (which is roughly where Greece is at the moment).

In our model, the key perceptions are those of the Chinese Government. When they are unhappy with Washington (as they have been recently), then we see that as a signal that something significant could be in the offing.

With best wishes,

Stephen

PS Thanks for the clarification about public education in the US. It is important to mention that the Federal programmes are the junior partner in education delivery. As to its effectiveness, I'm afraid that I can't comment.