'Terrifying worldwide panic' looms

Global markets eye America anxiously as political deadlock in Washington makes a default more likely.

Investors are being forced to endure yet another episode of Nightmare on the Potomac, says Randall W Forsyth in Barron's. On 1 October America's federal government shut down after Congress failed to agree to renew the government's spending authority, which was due to expire as the tax year ended on 30 September.

The discretionary spending covered by this mandate ceased on Tuesday, with almost one million public-sector workers going unpaid. "Mandatory" spending on essential public services, including benefit payments and those relating to protecting life or property such as air traffic control was not affected. This "dysfunction" isn't new, as Morgan Stanley pointed out. Disagreements between the main parties in Congress have led to 17 shutdowns in the past 40 years. Most have lasted a few days, with the longest stand-off, in 1995, lasting 21 days.

Investors are relaxed

"Long story short, a government shutdown is problematic but decidedly non-catastrophic," says Matthew Yglesias on Slate.com. Unfortunately, the same can't be said about the other pressing fiscal issue facing the US: the cap on its debt ceiling. On 17 October the legal limit on how much the US Treasury may borrow to plug the gap between tax receipts and expenditure will be reached.

but beware uncharted territory

If it misses a payment on its bonds, that would amount to a technical default. And as US Treasuries "are meant to be the safest asset in the financial system", and thus underpin or affect practically all bond markets, this could cause a crisis. "There's no guarantee that it'll lead to a worldwide financial panic and a massive global depression, but there's honestly no guarantee that it won't." Nobody really knows, "and you should find that prospect terrifying".

The last time "Washington played this game" was in 2011, as Economist.com's Free Exchange blogpoints out. The deadline then was on 15 August. A deal was struck on 2 August. But between mid-July and the middle of August the S&P 500 dropped by 15%. And there are knock-on effects on the real economy as market sentiment has an impact on household and corporate decisions.

The silver lining here, according to Capital Economics, is that the US budget deficit has come down to 3.8% of GDP, thanks to the series of short-term deals in Congress over the past two years. So "there is little appetite for linking a new agreement to raise the debt ceiling further with fiscal tightening". That should temper a strong recent headwind for the economy.

However, Republicans and Democrats look further apart than ever. Republicans in the House of Representatives insist on linking the debt ceiling extension to denying funds to Obamacare, even though the healthcare law was passed three years ago. Obama won't negotiate over the debt ceiling at all. "We would be lying," concludes Capital Economics, "if we said we were confident of a positive outcome."

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