The US debt ceiling fiasco is hugely damaging to the global economy

Politicians are playing a dangerous game by failing to compromise as the default deadline looms

‘This time, the dispute is an order of magnitude more menacing’

It is usually safe to ignore ritual brinkmanship over the US debt ceiling. The administration of the day invariably warns of “catastrophe” if the US Treasury is forced to default.

Opponents in Congress invariably take their bluff to the wire. They compromise a day or two before the drop-dead date.

This time, the dispute is an order of magnitude more menacing. It is barely two years since 147 Republicans in Congress voted to overturn the presidential election, in spirit with the mob that stormed Capitol Hill on Jan 6 2021.

Whether or not you deem this insurrection to be an attempted coup, it indisputably tells us that timehonoured conventions in Washington no longer apply. Anything can happen.

The traditional ideological battle over the size and purposes of the US federal government, combustible enough, is this time overlaid with an even more combustible battle over climate policy. This dials up the militancy to new heights on both sides.

House Republicans are demanding $4.8trillion (£3.8trillion) of spending cuts over 10 years and the evisceration of Joe Biden’s Inflation Reduction Act, his answer to China’s bid for clean-tech supremacy.

Since the Democrats regard this moonshot package of tax credits and bungs for electric vehicles, energy storage, clean fuels, solar, hydrogen, smart grids, and carbon capture as both the signature achievement of the Biden era and an existential matter for mankind, it is hard to discern any common ground.

One might ask why the Democrats did not raise the debt ceiling when they still controlled Congress, and why they did not repeal the law altogether if, as they say, it is an insane way for any country to run fiscal policy. As the editorial board of The New York Times thundered this week, the Democrats picked this fight.

Wall Street has remained insouciant but credit derivatives are flashing warnings that ought to give pause. One-year credit default swaps measuring US bankruptcy risk have spiked to an all-time high of 150 basis points.

Nothing close to this has ever been seen before. Germany is today at 2.5, Japan 5, the UK 7.5, Switzerland 11, and Italy 39. You can argue that the CDS market is notoriously thin, but pricing for treasury notes has also gone haywire.

Mr Biden can resort to outlandish measures, and let the Supreme Court decide what is legal. The US Treasury can mint a $1trillion coin and pawn it at the Federal Reserve for a fiscal hand-out. Mr Biden can do what Eisenhower did in 1953 by mobilising the Treasury’s passive gold reserves. Author Jim Rickards estimates that this could conjure $500bn if bullion was revalued at market prices.

The president could invoke the 14th Amendment and declare the debt ceiling to be unconstitutional, but that would be a declaration of political war.

He is condemned to two plausible choices: he can negotiate with a Republican House that is itself being held hostage by firebrands from the Freedom Caucus; or he can stare them down in a game of nuclear financial chicken, betting that they will capitulate once pensions and salaries stop being paid.

A Fed study estimated that a technical default for one month would cause a 30pc crash in equities and a 10pc fall in the dollar. This is pure conjecture. US debt is the anchor of the world’s dollarised financial system. Nobody knows what would happen if the chain broke.

We can reasonably assume that the Fed would step in to prevent Armageddon, mopping all defaulted issues of debt at face value until the bond market had stabilised. But that would not settle larger questions about the credibility of US financial management.

Standard & Poor’s stripped the US of its AAA sovereign rating for the first time in history after the 2011 debt fight, sending tremors through the markets. Other agencies held fire but they may not be so forgiving today. Fitch has already warned that the US is playing with live ammunition.

There will be mechanical consequences if the downgrades broaden: AAA bond funds will have to jettison treasuries; corporate collateral will be thrown into turmoil. “The bottom line is that foreigners own around $25trillion of portfolio investments in the US, and almost half is debt securities,” said Craig Chan from Nomura.

The US Treasury hit the debt ceiling in January. It has kept going since by finding pennies hidden in the mattress and by running down its Fed account by $300bn, which adds unsterilised macro-stimulus to the financial system. Treasury secretary Janet Yellen said the drop-dead date could be as soon as June 1.

The consequences of the debt fight will be contractionary with or without a deal. If they cannot agree, spending cuts will hit at a pace of $300bn a month over the summer. “A delay of any more than a few days could be really damaging because you would pull a lot of money out of the market,” said Alec Phillips from Goldman Sachs.

If they do a deal, it still implies a major fiscal shock to the US economy. The Treasury’s Fed account will have to be replenished, this time draining macro-stimulus by several hundred billion in a reverse flow. The budget settings will lurch from Rooseveltian largesse to something closer to austerity. This will worsen the enveloping credit crunch and further threaten over 2,000 US banks already underwater on their assets. It raises the risk of a deep recession.

Republicans are right to worry about America’s corrosive debt trajectory. The gross debt ratio was 104pc of GDP in 2014 (IMF data). It will be 136pc and rising by 2028. But the amputation method of the debt ceiling is not the way to stop the rot.

John Maynard Keynes must surely be spinning in his grave at the serial mismanagement of US fiscal policy. Congress prolonged the post-lehman slump by overdosing on austerity when the economy was still floundering, with an output gap of 4pc of GDP. This forced the Fed to compensate with QE.

America’s policy machine then lurched the other way, spending with shocking abandon, under Trump and Biden alike, after the economy had reached full capacity and was overheating. The House now wants to repeat the cycle by tightening hard into a downturn. The errors are almost pathological.

There is much ruin in a great nation. The US has vast reservoirs of commercial and technological creativity. But even Americans can run out of luck if they persist with this saga of fiscal pandemonium.