I rang some people at big banks this morning, who do the liquidity and balance sheet management, to see how they are preparing for the August 2 deadline for US debt funding. They seems remarkably sanguine. The feeling is that the President and the Congress will take the US close to edge, but not over it. I am not so sure. The positions of the two parties look very entrenched and hardline to me. They are so far apart that one or both parties will have to back down to get a deal done, and that is unlikely. My guess is that one of three things will lead to a resolution. In order of likelihood they are:
1. The parties go past the deadline (over the edge) and the Treasury suspends payment of Social Security checks and federal government wages and salaries, including military salaries. The resultant public uproar then forces the parties to do a deal — probably a short term extension to the debt ceiling.
2. A meltdown in the markets before August 2 forces the parties to do a deal — again most likely a short term extension. A meltdown means a collapse in stock prices. The dollar could collapse, but that won’t precipitate a panic by the US public — it might even be seen as a good thing. US Treasury prices won’t collapse either, because despite everything US Treasury bills are still the risk free asset (to USD investors).
3. A grand bargain is worked out. A way out of the impasse is to take negotiations to a higher level. Both parties give up a lot to get a lot, so both can be seen as winners. Giving up a lot means: for Republicans big tax increases and for Democrats deep cuts to social security and medicare.
None of these scenarios leads to a default on US Treasury securities. I think it is very, very unlikely that any coupon payments will be missed or that any bills won’t be fully paid out at maturity. That really would be a disaster. Security holders will be treated like they have a senior claim on the US Government and other claimants, such as Government employees and dependents will have their payments frozen.
Republican resolve in this matter should not be underestimated. The Tea Party’s effect on the party has been dramatic. It seems that no Republican member of Congress can afford to be seen to be soft on fiscal discipline. Otherwise they will face a stiff challenge from a Tea Party candidate at the next primary for their seat. Hats off to the Tea Party for bringing about that change, because regardless of the current crisis the US is heading for fiscal disaster unless it stops spending more than it taxes.
Another reason that the dispute will go to August 2 and perhaps beyond is that many Republicans are not convinced that passing the deadline will be that bad. And, they may think that this crisis is an opportunity to fatally wound President Obama. Think back to the impeachment and trial of President Clinton. 50 Republican Senators voted to remove an elected President from office for lying about consensual sex. That was a gross subversion of the constitutional process. Impeachment and trial is reserved for high crimes of such as bribery or treason. The impeachment and trial of President Clinton showed how crazy the Republicans can get. They hated Clinton more than they loved America. Don’t be surprised if Congressional Republicans get a bit crazy in this episode. They think they have President Obama cornered. He can’t agree to their demands, he can’t back down and if a crisis eventuates, then he will be blamed.