U.S. gov’t about to reach its debt ceiling; political infighting could trigger recession

When we buy or sell something, the exchange involves a transfer of money. The unit of payment is the Canadian dollar and is termed the medium of exchange.

Canadians have a high degree of confidence that their dollars will be willingly accepted at face value as payment. If we were to experience a high level of inflation, say 100 per cent or more per month, then the acceptability of the dollar would plummet and economic activity would shrink.

In international trading, the de facto medium of exchange is the U.S. dollar. Financial assets denominated in U.S. dollars are a primary store of value and are willingly accepted worldwide by trading nations as payment for everything from commodities to services. This acceptability is a function of the size of the U.S. economy, the depth of its financial markets and a belief that the U.S. Treasury will always be willing and able to pay its debts.

Now, however, there is a real possibility that the U.S. will default on its debt due to a law which limits the size of the U.S. debt. The current limit on that debt is fast approaching and will probably be reached by mid-October.

Unless that ceiling is lifted, the U.S. Treasury will be unable to borrow legally. Because the U.S. government’s expenditures are greater than its revenue, it may soon be unable to pay all its bills, and particularly the interest on its debt. Imagine the unenviable position of a government (say, Canada’s) holding a substantial amount of U.S. Treasury notes as reserves used for covering periods when its imports exceed exports.

Suddenly those reserves lose a portion of their realizable value. The medium of exchange becomes less certain because the risk of holding U.S. securities rises.

This uncertainty will have an impact on the willingness of governments to hold U.S. dollar assets. The primary way to overcome such reluctance is to pay a higher rate of interest. An increase of just 0.2 per cent in the rate paid on the U.S. debt would cost the U.S. Treasury more than $400 billion over the next 10 years.

The debt ceiling is a politically imposed limit and the suicidal decision not to raise it would be Congress’s choice. In a rational world, here should be no problem; an Act of Congress would raise the ceiling.

But things aren’t normal in Washington these days. The Secretary of the Treasury, Steven Mnuchin, really has no government experience and little understanding of the posturing within Congress.

Moreover, he is facing opposition from the head of the Office of Management and Budget (OMB) who believes breaching the debt ceiling would have little consequence.

He believes hanging tough on the debt ceiling will provide an opportunity for the far right Freedom Caucus (a.k.a. Tea Party) to advance its agenda, in particular cutting back on entitlements such as Social Security and Medicare. Caucus members believe that the government can simply prioritize which bills it will pay.

The problem is that all valid claims against the U.S. are backed by the credit of the U.S. The Constitution does not contemplate treating some claims as senior to others. The deliberate nonpayment of some claims constitutes default. The resulting class action suits against the government would keep lawyers busy for decades. Moreover, most economic policymakers believe that, as unpaid government bills mount, the crisis of confidence would trigger a major recession.

The Republican leadership in Congress fears that, if the Democrats and reasonable Republicans unite to pass an increase in the debt ceiling, these leaders would lose their jobs to a Freedom Caucus revolt and the GOP might be fatally fractured. The disorganized Trump Administration has yet to indicate its support for raising the debt limit. Thus petty U.S. domestic political issues have a good chance of causing a worldwide disruption to trade and the global economy.

The primary beneficiary of such self-defeating stupidity? That would be China.

David Bond is an author and retired bank economist. Email: curmudgeon@harumpf.com.