Far from risk-less

US default avoided, for now

The presidential administration in the United States and the Opposition-controlled House of Representatives leadership have announced that they have come to an agreement in principle on raising the “debt ceiling” — the legally mandated level of debt that the US federal government can take on, which currently stands at about $31.4 trillion, until January 2025. This will come as a great relief to investors and others not only in the US but also in the broader world. The federal government is expected to run out of money on June 5 or thereabouts. It may have been able to meet its debt repayment requirements for some time thereafter by holding back on other expenditure, such as salaries. But the prospect of defaulting on some of its debt would then become very real. A US default would have been catastrophic for the markets; it is very hard to predict what the short-term effects of such a shock would have been, let alone the longer-term repercussions.

US sovereign paper is generally assumed to be as close to a classical, theoretical riskless asset as can be achieved in the real world. Multiple other financial structures are predicated upon that assumption. A default would have caused that assumption to be rendered untenable — and therefore changed behaviour across hundreds of unrelated financial markets. Banks, companies, and governments would have had to reprice and re-allocate their capital as a consequence. Risk appetite would nosedive, and financial flows into countries like India would almost certainly suffer greatly.

The deal that has been announced is therefore a major achievement. That it has been attained without any brinksmanship is also a tribute to the skills of both the President and the current Republican speaker of the House. The Republicans have achieved some level of spending control; the Democrats have protected some of this administration’s signature new programmes from cuts. However, this saga is far from over. The extremes of both parties are unhappy. It is unlikely, but possible, that the rightmost edge of the Republican Party is able to make enough noise and corral just enough votes to make it difficult to get this deal approved before June 5. But, even if it is approved, the compromise will last only until the next election in 2024 is over.

Thus, similar risks will arise again once two years have passed. If both Congress and the White House are controlled by the same party, it is unlikely that any confrontation will occur. But if they continue to be under two different and opposing parties, and if the extreme factions of both parties continue to gain in strength, then any future deal will be even more complicated than this one. The broader question of the risk attached to US debt therefore can no longer be ignored. Can assets with a structural risk of default in this manner really be regarded as risk-less? It may be wise for economists and investors to start discussing how to price in this tail risk, or to restructure the global economy to ensure any temporary US default is less catastrophic than it would have been on this occasion. A big shift from US government bonds — some central banks are doing it already — could also destabilise global financial markets and increase risk aversion.