In my previous blog post, I argued that the costs of the government shutdown on the real economy were, in the context of the media attention and the long-term fiscal issues, ‘small.’ And yet, the government shutdown seems to have hit consumer confidence hard, lowering it to levels seen early in the Great Recession in 2008.
In this post, I look at financial markets for answers. I focus in particular on perceptions of the possibility of delayed debt payments, technical default and (gulp) actual default (emphasis: the effect of beliefs rather than actual default). I make four points. First, there were observable ripples in the market for government debt. But only ripples. Short rates were raised by the shutdown, but only short rates, not forward rates. So markets expected rapid resolution. Second, while rate increases raised borrowing costs, the additional cost for the government budget is far less than the costs discussed in the previous post. Third, why did short rates move at all in zero interest rate environment? Interestingly, I think they did because the market thought “payment-delayed” Treasury debt was not going to have the liquidity and safety features of the rest of the debt. So the event provides a neat window into the liquidity benefits of Treasury debt. Finally, we are still left with the question of why the shutdown was such a big deal. I propose one answer: it raises the specter of default, or even, perhaps more accurately, the specter of others perceiving that default is a nontrivial possibility. And if markets perceive that a US default is possible, then even without actual default, lots of very bad scenarios are in play. This answer is not the only answer. Learning that your government is disfunctional is bad news on many fronts. But market reactions to these beliefs can create economic disaster, with costs many times greater than those of the actual shutdown.
First, the shutdown did raise interest rates on US government debt. Higher interest rates make new borrowing – to fund the deficit and to roll-over the existing debt that comes due – more expensive. Maybe the budgetary effects of the shutdown through increased borrowing costs were substantial? Turns out the answer is no.
To measure the effects of the shutdown on interest rates, I look at the movement of interest rates around the resolution of the shutdown. Why the resolution and not the initiation of the shutdown? Because market expectations of a shutdown slowly rose as we approached the debt limit, and during this time other factors might also be moving yields. Because the news about the end of the shutdown was released relatively rapidly, the fall in government rates reveals the change in borrowing costs that the Federal government experienced as a result of the shutdown.
The following table from the Selected Interest Rates (H.15) release from the Board of Governors of the Federal Reserve System shows several things. From October 15 to 17th (the deal to end the shutdown was announced October 16th 2013), the annualized yield on one-month nonfinancial commercial paper falls by 5 basis points (0.05 percent) while the yield on treasury bill coming due in a month fell by 31 basis points (a third of a percent). (Note that these rates are estimates constructed from rates on securities of similar term.) If markets were sure that the shutdown would not affect payments on debt due beyond one month, then there would be no effect on forward rates, and the movement in the three-year yield ought to be approximately 1/3 the movement in the one month yield. And that is what we find: thee month annualized yields fell by only 9 basis points. (Note that all yields rise with the horizon – this is business as usual. Yields curves on government debt usually slope up.)
How much might this have raised the cost of borrowing for the U.S. government in this period? In 2012, the Treasury issued about $650 billion in Treasury debt each month. Take this as an estimate of monthly borrowing during our period of interest. Further, following our above calculation, suppose that the borrowing rate for half of October was raised by a third of a percent at an annual rate. Finally, let’s assume that this rise was anticipated (fully and only) for three months, so that the government shutdown raised rates starting three months prior to the shutdown. Then the total costs on Federal borrowing are one third of a percent higher (forward) interest rate covering a two weeks affecting borrowing over three and a half months, or roughly: (.00333) * (2/52) * ($650 billion) * (3.5 months) < $1 billion. Not only is this calculation rough, but it plays quick and dirty with compounding. But it makes the point. The costs on borrowing are smaller than estimates of the direct costs on the economy. Increased borrowing costs cannot explain the nosedive in consumer confidence.
But this data raises an interesting question: why did the one-month yield move at all? The only risk that I heard about in the markets was the risk that debt payments would be delayed for a short time. If rates moved because of default fears, long rates would have moved more. They did not. So why would a Treasury bill that is yielding an almost zero rate of return suddenly have its yield rise by a third of a percent (annualized) at the threat of having its payment postponed? The puzzling part is the “nearly zero interest” part. If yields were 10 percent per year, then a postponed payment — effectively being forced to give the government an unexpected loan at a zero interest rate — would have real (opportunity) costs. But in a zero interest rate environment, no.
The answer I think lies in the almost unique features of US debt: its perceived safety and liquidity. These properties mean that Treasury debt serves as money for large US firms, foreign governments, and companies that do business all over the world. As the budget fiasco emerged, markets perceived that payment might be delayed on Treasury debt due to be paid after the government hit the debt limit, and, more interestingly, that this delayed-payment Treasury debt would not have the liquidity and safety properties of not-yet-expired Treasury debt. Thus the yields on this debt rose. But the yields on long-term debt did not, even though it was just as possible that coupon payments also might have been delayed. So, and somewhat speculatively, it appears that the perceptions of the liquidity of long-term US government debt were largely unchanged. (I conclude this because we see similar movements in interest rates on long-term highly-rated corporate debt as for long-term Treasury debt. But this is a subtle quantitative question and I have not done the hard work — let me know if you have!) My speculation is that what we saw in yields is that, for long-term debt, safety matters. For short-term debt, liquidity is critical for value.
Why? Businesses use the Treasury debt like you and I use money. Businesses hold Treasury debt rather than money because Treasury debt pays interest and Treasury debt is safer than large accounts of cash which are not insured and more convenient than cash (which also can be stolen, lost or damaged). Liquidity means that if a large corporation or other government wants to make a payment, it can easily sell the Treasury debt and get cash. Or it can rehypothecate or ‘repo’ the Treasury debt, borrowing against this extremely safe collateral at a low interest rate (even in times of crisis). Or finally, it could simply make payment with Treasury bills – among large firms Treasury debt is often the means of payment. US Treasury debt is the main international money supply of global businesses and governments.
The U.S. gets significant seignorage from this special feature of Treasury debt. We get to borrow more cheaply. This figure, (from this paper by Arvind Krishnamurthy and Annette Vissing Jorgensen), shows something like a demand curve for Treasury debt. The vertical axis is the price – the lower yield that one accepts by holding Treasury debt instead of a diversified portfolio of highly rated (Aaa) corporate debt. When there is a lot of Treasury debt in the U.S. economy relative to the size of the economy (the horizontal axis, debt/GDP), the difference in yields is about 0.4 percent. But when there is less debt outstanding, people don’t simply hold diversified highly rated corporate debt instead. They have a need for Treasury debt. And this need is so strong that people, firms, and governments are willing to hold and use Treasury debt even when they are getting one and a half percent per year lower returns than the diversified pool of AAA corporate debt. Krishnamurthy and Vissing Jorgensen estimate that this benefit of liquidity and safety have on average lowered the borrowing costs of the US by about 3/4 of a percent per year. Obviously, this amount is higher when there is less debt, but this seignorage helps the US budget significantly (these amounts are much, much larger than any estimate of the effect of the shutdown to date).
Did the government shutdown change this liquidity premium? Did it affect the liquidity and safety of Treasury debt or its widespread use as money? The shutdown only caused tiny ripples in the overall market for US government debt. I saw some reports of a few financial businesses not accepting Treasury bills. And the shutdown seems to have affected the one-month yields only, as I showed above. So, the basic answer is no. The yield on very short debt rose, because it may have become illiquid and the people who hold it are those that value liquidity. But the possibility of delayed payment did not bother investors with long-term government debt.
But it is here where the real danger of the government shutdown (and its deeper causes) lies. It raises the possibility that US Treasury debt might someday lose its special status as the money supply of global business. And this would happen if markets more seriously thought the US might default. And the shutdown raised this possibility.
If people thought that people thought that the US might default in some unlikely but not impossible state of the world, then Treasury debt would no longer have safety and its yields would become more volatile. And it would no longer have liquidity and it would lose its status as the world’s money supply. This would be bad for the US. First, the US would lose the special terms at which it can borrow and lose the seignorage that come from liquidity and safety. But one country’s loss would be another county’s gain. Second, the US has very high debt levels. A rise in borrowing costs pushes the long-term fiscal imbalance issues to the fore much faster. And finally, as long as we are running significant deficits or rolling a significant amount of debt, a significant rise in rates raises the possibility of a run on the dollar. The US could quickly be put in a position where creditor doubts could raise rates or severely limit US government access to credit markets and require immediate, and under current projects, massive cuts in spending and increases in taxes. I won’t use the word ‘default’ here, but the recent experience of Greece and Italy come to mind, and I don’t see anyone big enough to play the role for the US that the ECB has played for parts of Europe. Gulp.
But that is not all. Even without a run on the dollar, a switch from US Treasury debt as the global money supply to some other currency and debt instrument would not go smoothly. This switch alone would cause a global recession. Because the firms of the world currently use Treasury debt like money, a sudden collapse in the perception of the Treasury and the dollar as safe and liquid would be like a massive contraction of the money supply of global economy. It could easily lead to a deep global recession. It is almost impossible for such a switch to occur in an orderly way, because a switch to a new currency is only effective if fast – if people are using different moneys they find it hard to transact, so we need everyone to switch at once – but coordination is difficult and preparation nearly impossible. Markets are forward looking; they would start to react before plans could be set in motion. Would you accept Francs as payment if you knew that next week there would be a different currency? The transition to the Euro worked in Europe (but not the UK) because the central banks were willing to trade at a fixed price. There is no World Central bank (and the IMF and World Bank have very few funds relative to US Treasury debt). In this scenario, the perceptions of the perceptions of others – market psychology – could start to matter. The global economy would be at mercy of whether markets believed that the US dollar and US debt would no longer be the world’s currency. Increases in this belief would cause large disruptions in trade and economic growth.
What I have outlined has ignored the massive disruptions that an actual default would have on the US and global economy, where Treasury debt is relied upon by banks, insurance companies, pension funds and so forth as a store of value.
Did the shutdown take us part of the way there already? I don’t know. Just because long rates on Treasury debt did not decline much as the shutdown was resolved does not mean that move to and through this shutdown did not raise them.
I do not mean to be too pessimistic. I expect the US to solve its long term fiscal imbalances and to rule out the possibility of default before it becomes a significant enough of a concern to cause some of the scenarios that I just sketched. I wrote this post because I think these financial market concerns are at heart of the puzzlingly strong reactions of the media and consumer confidence to the recent Federal government shutdown. The direct and indirect effects of the shutdown that we have observed are quite small in the scheme of things. The danger lies not even in another shutdown—the US averaged a shutdown a year between 1977 and 1987 – but in the possibility of future shutdowns combined with high level of national debt and large deficits. I am concerned about the extent of political conflict and of the open discussion of default as a possibility even among some of our political leaders.
Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.