Viewpoint on the Government Shutdown

The direct impact of the shutdown on output should be fairly small.

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The direct impact of the shutdown on output should be fairly small. First, only about 800k out of 2.1 million federal government employees are being furloughed, according to J. David Cox, president of the American Federation of Government Employees. The remaining 1.3 million will still show up for work, because they are either:

a) not subject to annual appropriations (that would be the case of the Postal Service, or the Federal Reserve, for instance); or

b) subject to annual appropriations, but necessary to carry out activities that are not subject to the annual appropriations (Social Security Administration, for example); or

c) essential to protect life or property (which includes the Department of Homeland Security, TSA, FEMA, the Department of Transportation, Veterans’ Affairs, the Department of Justice, which includes the FBI, active duty military, and about half of the Department of Defense’s civilian employees).

Only activities funded by congressional appropriations are affected. Goldman Sachs estimates that a weeklong shutdown would reduce growth in the fourth quarter 0.3 percentage points at an annualized rate.

If federal spending is funded within weeks, and furloughed employees are paid retroactively (as they were during the 1995 shutdown), the main effect would be a partial delay of spending planned for this month into the next month. The 28-day shutdown in 1995 subtracted about 1% from annualized GDP growth in Q4. However, that year, most of the shutdown period was toward the end of the fourth quarter, so there was effectively a delay of 1995:Q4 expenditure into 1996:Q1 expenditure. This time around, the shutdown is happening at the beginning of the quarter, so the spending delay will probably occur within the quarter.

The more important impact of the shutdown is that it raises the market’s assessment of the probability of a government default. If Congress is dysfunctional enough to force a shutdown, the reasoning goes, maybe it is dysfunctional enough not to raise the debt ceiling. The Treasury expects that by October 17, it would have only $30 billion left, an amount sufficient to function for only one or two more weeks, at most. Because the Treasury would not be able to borrow and the federal government operates at a deficit, the Treasury would be unable to make some payments. In order to reduce payments another government shutdown would be likely. Hitting the debt ceiling would essentially force the government to balance its budget at once—at present, it is running an annual deficit of about 4% of GDP. Analysts at Bank of America Merrill Lynch estimate that the government would have to slash spending by 20%. That would almost certainly trigger a recession. However, I think that a sovereign default would not occur.

My expectation is that the Treasury would prioritize payments. On average, the Treasury takes in about $225 billion per month in tax receipts. It spends just $35 billion on debt interest, according to the Monthly Treasury Statements of the Treasury’s Financial Management Service. I expect that the Treasury would make interest payments first, to avoid a default. (Rolling over maturing debt should not be a problem, as it does not raise the amount of debt outstanding.) Granted, hitting the debt ceiling still means that the salaries of some federal employees, payments to vendors and contractors, and other non-critical payments would not be made, but a sovereign default would be avoided.

There is no playbook here, however, because a default has not happened before, and the Treasury does not (officially) have a contingency plan that states which payments will be made, or when, or in what proportion. A report by the Treasury inspector general, however, is strongly suggestive. Responding to an inquiry about the Treasury’s contingency plan for the 2011 debt ceiling impasse, the inspector wrote:

“Treasury considered asset sales; imposing across-the-board payment reductions; various ways of attempting to prioritize payments, and various ways of delaying payments. We were told that similar options had been evaluated by previous administrations during debt limit impasses. That said, Treasury reached the same conclusion that other administrations had reached about these options—none of them could reasonably protect the full faith and credit of the U.S., the American economy, or individual citizens from very serious harm. However, Treasury officials told us that organizationally they viewed the option of delaying payments as the least harmful among the options under review. Ultimately, the decision of how Treasury would have operated if the U.S. had exhausted its borrowing authority would have been made by the President in consultation with the Secretary of the Treasury.”

The inspector acknowledges the possibility of prioritizing payments, and eventually states that ultimately the President would have made the decision as to how the Treasury would operate. Maybe I am too optimistic, but I think that the President, in consultation with his advisors, would at the very least prioritize debt payments to avoid a default. The consequences of a default are too ghastly even to consider default an option.

That said, the market has started to price in a higher probability of default. The price of credit default swaps on Treasury debt rose from €5,000 on Sep. 20 to €35,000 on Sep. 30, according to Markit data (U.S. debt CDS are quoted in euros). The implied probability of default in that price is still tiny, but the fact that it rose is meaningful. The S&P 500 has lost about 1.7% since Sep. 18. The yield on the 10-year note, on the other hand, has come down from about 3% in mid-September to 2.6% now, as, somewhat paradoxically, investors seek refuge in Treasury debt. I expect the markets to continue moving in this direction, if anything at a faster pace as we approach Oct. 17.

I also think that neither the government shutdown, nor a delay in raising the debt ceiling (if it is done within weeks) would prompt Standard & Poor’s to downgrade the credit rating of U.S. government debt. Federal finances have improved significantly since S&P downgraded the U.S. in 2011, as highlighted in the research note that the company released when it upgraded the rating outlook from “negative” to “stable” in June 2013. On the other hand, if the debt ceiling stalemate continues beyond Oct. 17, I would expect the rating agency to bring back the outlook to “negative.”

That is not to say that neither a shutdown nor a failure to raise the debt ceiling is important. Either event disrupts the normal operation of hundreds of federal government agencies and of private-sector companies that do business with them. Uncertainty over public policy forces managers in both the private and public sector to put projects on hold, or scrap them altogether. Market volatility increases. The reputation and trustworthiness of the country in the international arena are eroded, slightly in the case of a shutdown, and greatly in the case of a default.

 

Francisco Torralba, Ph.D., CFA, is an economist with Ibbotson Associates.

Ibbotson Associates is a leading independent provider of asset allocation, manager selection, and portfolio construction services. The company leverages its innovative academic research to create customized investment advisory solutions that help investors meet their goals.

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Francisco Torralba, Ph.D., CFA  Francisco Torralba, Ph.D., CFA, is an economist with Ibbotson Associates.

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