Impacts of the U.S. Budget Freeze

With the U.S. government failing to reach agreement on budgetary issues and on raising the debt ceiling, there is considerable discussion of what this would really mean.  From what I have read, the issues are quite straightforward.  If the U.S. government does not raise the debt ceiling, the Treasury will not have sufficient funds available to meet all of its obligations, starting sometime in mid-October.  For the time being, many government workers have been furloughed and services suspended. 

I have yet to read any credible analysis that suggests that a default on debt is likely, but it is perceived as possible.  My read on this is that the opposing sides both realize the magnitude of the stakes, but that both are willing to engage in a process of brinksmanship until the last possible moment.

In the worst case scenario, without an agreement, the U.S. Treasury will probably start to miss bond payments in October.  A default on bond payments would significantly impact the global economy.  As soon as the U.S. government misses payments on its debts (Treasury bonds), investors around the world will start to sell bonds, driving yields up (and prices down).  In addition, new bond issues will require higher yields to attract investors.  Higher bond yields mean that it is more expensive for the government to borrow, increasing the costs of running the government.  This event would have enormous implications for the U.S. globally because the dollar is perceived as the global ‘reserve currency,’ a safe haven and this, in turn, means that U.S. Treasury bonds are treated as though they have zero default risk.  Missed bond payments throw this status into question.

I will be somewhat surprised to see government bond yields soar in response to the possibility of default, although that is what would happen if the markets actually believed that a default was coming.  I don’t think that anyone believes that money invested in U.S. Treasury bonds is actually at risk of not being repaid. The more likely outcome, in my opinion, is that this situation will be resolved but that the stalemate, furloughs, and consequent uncertainty about the government’s ability to facilitate a return to economic health will result in less spending, less hiring, slower growth, and an increased probability of another recession.  This outcome would result in falling bond yields and falling stock prices.

While furloughed government workers will receive pay for the period that they are off, once this situation is resolved, the uncertainty that these people have faced makes them less likely to spend and more likely to save.  I was employed by NASA during the 1995-1996 shutdown, and the end of the furlough certainly didn’t make me want to rush out and spend money.  To the contrary, having been classified as having a ‘non-essential’ role made me feel very insecure about my financial situation.  In addition, many government contractors are quite likely to feel the same.  On a broader scale, the level of political dysfunction evidenced by the current squabbling between the executive and legislative branches is likely to discourage companies from major capital investments in new projects, which then cuts potential economic growth.

In the final analysis, I expect the government shutdown’s primary effect to be to further slow an already anemic economic recovery.  The Fed will probably respond by holding off on tapering its bond purchase program known as quantitative easing, but this will not accomplish much in terms of encouraging a return to economic growth and higher employment if consumers and companies are both feeling deeply unsettled by the lack of a consistent action across the government.

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