Earlier we showed that following a report by Axios which quoted a republican who put the chance of a shutdown "as high as 75%", the T-Bill market got spooked, and pushed the Oct.12 Bill - the one considered closest to the Treasury's X-date - to the widest spread on record from the nearest "safe" Bill, maturing on Sept. 28.
And as more traders start asking questions, in the latest report laying out both the threat, and potential consequences from a government shut down and/or debt ceiling crisis, Barclays' Shawn Golhar tried to ease growing concerns and wrote that while Barclays "does not expect" either a shutdown or debt limit breach, he admitted that "the cumbersome legislative process, a limited number of Congressional working days in September, burgeoning tensions between President Trump and Congressional Republicans, and repeated demands by the president that any budget agreement include border wall funding raises the risk of a government shutdown and/or debt ceiling breach that goes against our baseline assumptions."
What makes the upcoming negotiations more complicated is that a potential government shutdown is a discrete event that is different from a debt ceiling breach, i.e. a technical default. In other words, in addition to lifting the borrowing capacity of the Treasury, Congress needs to complete the FY2018 budget process or pass a continuing resolution by October 1, 2017. If that does not happen, the federal government will shut down for the second time in the past four years.
The good news here is that despite the ominous rhetoric, short funding gaps are a regular feature of the budget process, even if they have become more pronounced in length in recent decades.
The Barclays chart below shows that since 1976, the federal government has experienced 18 funding gaps under the current budget process, "although most did not result in a shutdown of operations and a furlough of non-essential employees. Since 1980, following new interpretations of the law, government shutdowns have generally coincided with employee furloughs. This is particularly true during the three most recent lapses in government funding – November 1995, December 1995-January 1996, and September-October 2013 – which are often referred to as true shutdowns. Also, funding gaps do not solely coincide with divided government; five in the late 1970s occurred under one party rule."
Assuming the worst-case, and the government does shutdown on October 1, as it did briefly in September 2013, what then? In short, a shutdown would not have a sudden, adverse impect, but instead would subtract from US output slowly but surely. Barclays estimates that a shutdowns typically reduce real federal government consumption and gross investment 1.5% q/q and annualized GDP about 0.1% per week.
Which is good news, because while the chart above shows that shutdowns occur with some regularity, their effects are largely political, particularly if the shutdown is short-lived. Furthermore, the lack of current income for millions of government workers and the political outcry to get a deal down at the grassroots level as government procurement contracts are put on halt, crippling downstream private industries, results in political pressure to reach a compromise. As a result, a shutdown would have to proceed for several weeks or more to have sizeable economic effects. Here are the details:
In the NIPA accounts, a government shutdown is primarily reflected in a decline in real compensation of non-essential employees as a result of reduced hours worked. In the 1995- 96 shutdown, approximately 800,000 of 2.04mn federal civilian (non-postal) workers were forced to take leave without pay, or about 39% of employees. In the shutdown of 2013, about 850,000 of 2.19mn federal civilian employees were furloughed (a similar 39%). That said, then-Secretary of Defense Gates ordered about 400,000 civilian military employees back to duty after the first week of the shutdown, leaving 21% of federal civilian employees furloughed in weeks 2 and beyond.
In addition to compensation costs, the effects of the shutdown are felt primarily in services consumption. A temporary government shutdown at the beginning of Q4 could result in shifts in investment spending from one month to the next and increase the volatility of inventory data, but would be unlikely to disrupt federal consumption of fixed capital and gross investment over the quarter as long as the situation were resolved before year-end. However, services consumption is unlikely to be recovered once halted. BEA estimates for non-defense expenditures unrelated to compensation are based on federal budget data, and a shutdown would be unlikely to alter these accounts unless it persisted past year-end or the BEA modified its procedures on applying annual budget data in its quarterly estimates.
So while a brief shutdown, one lasting 2-4 weeks would not cripple the economy, a longer shutdown "could have negative indirect effects on private sector activity."
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What about a debt ceiling breach?
Here things are more serious: according to Barclays, the consequences of a debt ceiling breach as more extreme and, therefore, less likely. First, a quick look at lessons from recent history:
The debt ceiling showdowns in 2011, 2013, and 2015, like many before, have led to the use of extraordinary measures to create borrowing room and prolong the date at which the debt ceiling is reached. Extraordinary measures plus the Treasury’s cash balance left about $280bn in operating capacity as of the end of June, but these measures are only temporary; cash balances at the Treasury have gradually moved lower, and borrowing capacity will eventually reach its limit (Figures 3 and 4). Policymakers are running out of time as the September budget and mid-October debt limit deadlines loom. The exact timing of the end of borrowing capacity is uncertain, and the risk of an unforced error is rising.
While the exact timing of the so-called X-date is still fluid (we will have more on this a subsequent post shortly), one thing is clear: in addition to a potential downgrade by Fitch and Moody's, it is the conomic consequences that would be most concerning: according to Barclays' calculations, failure to raise the debt ceiling would require an immediate cut in spending equal to about 3.5% of GDP (the federal deficit in percent of GDP in 2016 was 3.2%; the average of the most recent four quarters through Q2 17 was 3.8%).
Yet even cutbacks of this kind would not rule out a default because previous administrations concluded the Treasury does not have the authority to prioritize interest payments above other obligations. Even if revenues match expenditures in aggregate, federal receipts and payables differ in timing and quantity, and Treasury payment systems are designed to pay bills as they are received. Furthermore, even if the Treasury concluded it could prioritize interest and principal payments, it may still be viewed as a technical default since the government would not be meeting all its obligations.
In a separate report, the Bipartisan Policy Center calculated that losing the ability to borrow any more on Oct. 2 would mean approximately 23% of funds owed by the government that month would go unpaid, dealing an immediate blow to the U.S. economy.
Barclays' conclusion: "A contraction of federal spending of this magnitude, the risk of default, sovereign reputational risk, and negative consequences for confidence and private sector behavior would likely push the economy into a recession if the situation persisted. We view the consequences of a debt ceiling breach as extreme and, therefore, unlikely." Then again, a recession just 8 months into President Trump's presidency may be precisely what all Democrats, and quite a few Republicans, desire, so we are far less sanguine than Barclays about an imminent "happy ending."