Macro and Markets

The Annual Meetings of the World Bank and IMF this week look far different than expected a few weeks ago.  Here are five thoughts on what to look for. 1.    The dominant issue will be the U.S. fiscal mess as the central global risk and the primary driver of financial markets. Outside the United States, there is little understanding why we are engaged in such a destructive debate with so much at stake. Uncertainty about what comes next will hang over virtually all policy discussions. 2.    U.S. policy makers will be sidelined, both because the crisis will force them to take a low profile in the official meetings, and because the government shutdown will restrict their public appearances outside of the IMF meetings. (The conferences hosted by private financial institutions on the margins of the meetings are as important as the official meetings for getting a message out).  The lesson that our fiscal crisis undermines our ability to project our values and policies abroad will be on vivid display this weekend. 3.    The IMF economic outlook, released yesterday, stresses the risks associated with low export growth and the Fed’s exit from unorthodox policies.  Emerging markets in particular will complain about sudden stops in capital flows due to expectations of Fed tapering (they also complained about hot money inflows when industrial country central banks were launching these policies).  But while there will be sympathetic calls for close coordination of policy, emerging market policymakers will come away empty-handed. Central bankers see their policies as supportive for growth and appropriate on domestic grounds.  The message back to countries will be to move more aggressively to fix their own imbalances and let their exchange rates adjust as needed. 4.    I recently examined the case for a strengthening of the global liquidity arrangements through an expanded network of swaps.  I don’t expect any new deliverables this weekend, but there should be discussions about whether the Fund can and should do more to protect countries from volatile capital flows. 5.    Europe will get a pass. There is little confidence outside European capitals that their policies can restore growth, produce sustainable debt levels in the periphery, or reduce punishingly high unemployment rates.  In calmer times, there would be a vigorous debate over whether Europe is on the right track.  Not this week.

It is starting to sink in that October 17 is not a hard deadline for default by the U.S. government on its obligations.  Senator Corker for instance says “I think the real date is around the first of November.” Some of the talk of later dates is posturing by the president’s opponents seeking leverage in the negotiations, and their willingness to go so close to the edge of the cliff is disturbing. But it also reflects the real uncertainty about when the debt limit will cause serious economic and political distress.  It is worth examining whether November 1 is a drop dead date for negotiations. Best estimates are that, on October 17, when the Treasury exhausts the extraordinary measures that it has used to push back the debt limit, that it will have $30 to 40 billion in cash in its account, the prudent level of reserves it needs to manage the day-to-day fluctuations in payments.  They would then draw down those balances, and my best guess is that they have enough to make all payments through the end of the month.  But there is huge uncertainty around that, so what happens if they run out before November 1, as suggested by CBO and others? Ideas for evading the debt ceiling are either unrealistic (the $1 trillion dollar coin) or temporary moves that buy some time but create ill will and could make it harder to resolve the standoff (e.g., extending the extraordinary measures or issuing high interest rate/“premium” debt). The reality is that the government most likely will prioritize payments.  The president was rightly evasive on the issue of prioritization yesterday and an active debate about whether the government has the authority and ability to explicitly do so, but there are several scenarios that could play out where the government will make some payments and not make others.  Some bills will be delayed being submitted, some will be paid late.  This creates IOUs of the government, which we can believe with a great deal of confidence will be made good once the debt limit standoff is resolved. In that sense, it is the issuance of debt above the limit, exactly what has been debated in the context of the 14th Amendment to the constitution (“the validity of the public debt… shall not be questioned.”). Meanwhile, payments on the government debt are low through end month (the next large quarterly payment, around $30 billion, is November 15), and will be paid through a separate payments system (Fedwire), while Federal Reserve facilities to support the financial system as default is threatened are likely to drain “risky” debt from the system. What matters then is not just the size of the arrears created, but the dislocation involved.  To the extent that arrears initially can be limited to large vendors, it will not be devastating because they will have the cash reserves or bank credit to manage a short delay.  But for small and medium sized business, and for individuals (particularly lower income recipients of benefits), the issue is more complicated because they have far more limited ability to finance even a short delay in government payments or smooth consumption. What makes November 1 different is not just the large number of payments due that day, but also its composition:  Social Security benefits, payments to Medicare Advantage and Medicare Part D plans, pay for active-duty members of the military; and benefit payments for civil service and military retirees, veterans, and recipients of Supplemental Security Income total around $67 billion.  It is hard to imagine getting past November 1 without significant dislocations for those who are not paid.  So perhaps Senator Corker is right that Congress will act before then.  But there are no guarantees. What next?  One possibility is that the combination of market disruption and evident costs of the crisis force politicians to act, though at this stage the market moves (and short-term funding strains we are beginning to see) haven’t seemed to register on lawmakers.  The problem is that the risk of miscalculation is high, and in particular the effects of arrears on a complex and stressed financial system are extraordinarily hard to predict.  For example, we would like to believe that reforms since 2008 make it unlikely that a money market fund gets in trouble, but of course runs can develop if confidence is shocked. My base case is a clean short-term CR /debt ceiling increase with some sort of supercommittee to negotiate funding for the remainder of the year.  The deal to be had would allow a slight easing of the sequester for a small cut in entitlements. Alternatively, Chris Krueger at Guggenheim Securities says odds are rising of a clean, one-month debt ceiling raise (the “escape hatch option”) without the government reopening.  It’s terrible policy–and at least in the short term would reduce GDP in the quarter by as much as ¾ of a percentage point—but now has to be seen as one of the ways our politicians kick the can a very short distance down the road.