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Treasury Report: Potential Macroeconomic Impact of Debt Ceiling Brinkmanship

Treasury Report: Potential Macroeconomic Impact of Debt Ceiling Brinkmanship

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Published by Zeke Miller
Potential Macroeconomic Impact of Debt Ceiling Brinkmanship
Potential Macroeconomic Impact of Debt Ceiling Brinkmanship

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Published by: Zeke Miller on Oct 03, 2013
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06/11/2014

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U
.
S
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DEPARTMENT OF THE TREASURY
 
Introduction
 The United States has never defaulted on itsobligations, and the U. S. dollar and Treasury securities are at the center of the internationalfinancial system. A default would beunprecedented and has the potential to becatastrophic: credit markets could freeze, the value of the dollar could plummet, U.S.interest rates could skyrocket, the negativespillovers could reverberate around the world,and there might be a financial crisis andrecession that could echo the events of 2008or worse.Political brinksmanship that engendgers eventhe
 prospect 
of a default can be disruptive tofinancial markets and American businessesand families. The closest historical precedentis the debt ceiling impasse in 2011, around which time consumer and businessconfidence fell sharply, and financial markets went through stress and job growth slowed.In 2011, U.S. government debt wasdowngraded, the stock market fell, measuresof volatility jumped, and credit risk spreads widened noticeably; these financial marketeffects persisted for months. To be sure,other forces also played a role, but theuncertainty surrounding whether or not theU.S. government would pay its bills took a tollon the economy. An additional considerationnow is the government shutdown that startedOctober 1. If the shutdown is protracted, theeconomy could be weakened, making theexpansion even more susceptible to theadverse effects from a debt ceiling impassethan prior to the shutdown.It is clear from economic theory and evidencethat lower stock prices and wider risk spreadshave adverse effects on private spending, allelse equal. Because the debt ceiling impassecontributed to the financial marketdisruptions, reduced confidence and increaseduncertainty, the economic expansion was nodoubt weaker than it otherwise would havebeen. So far this year, Treasury yields havebeen rising on balance, which means that any adverse effects from financial marketdisruptions caused by a debt ceiling debatemay not be offset as it was in 2011.
THE POTENTIAL MACROECONOMICEFFECT OF DEBT CEILING BRINKMANSHIP
OCTOBER 2013
In 2011, U.S. debt was downgraded, thestock market fell, measures of volatility umped, and credit risk spreads widened noticeably.
 
 
 
U
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S
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DEPARTMENT OF THE TREASURY
 
2
 
THE POTENTIAL MACROECONOMIC EFFECT OF DEBT CEILING BRINKMANSHIP
The Experience of 2011 and the Linksto the Economy
 The financial market stress that developed in August of 2011 persisted into 2012 eventhough Congress raised the debt ceiling priorto the exhaustion of extraordinary measures.In this report, we discuss in more detail somechannels through which a similar episodemight harm the economic expansion. Inbrief, reduced household and businessconfidence, lower equity prices, volatility inthe stock market and increased corporate andhousehold borrowing costs all tend toundermine the economic expansion.
Household and Business Confidence
From June to August 2011, consumerconfidence fell 22 percent and businessconfidence fell 3 percent. Measures of bothhad already begun to fall earlier in 2011, inpart because of developments abroad, but asthe debate about the debt limit grew, thesemeasures of confidence fell further.Moreover, it took months before confidencerecovered fully, even though, in the end thedebt limit stand-off was resolved. Althoughthese measures of private-sector confidenceare not measures of spending or the directcosts of doing business, they capture themood of the private sector with regard tospending.
Financial Market Effects
Financial market conditions have a directeffect on economic activity. A good deal ohousehold wealth is held in financial assets,and much of household and businessspending is funded by borrowing. Thus,lower asset prices and higher borrowing coststend to weigh on private spending, and greateruncertainty about asset prices, borrowing costs, and economic activity can makehouseholds and businesses reluctant to spend.Stock prices, stock price volatility, credit risk spreads, and mortgage spreads all deterioratedin August 2011 and recovered only after many months.
Consumer Confidence
Index, August 2011 = 100
FIGURE 2
SOURCE: REUTERS/UNIVERSITY OF MICHIGAN, CONFERENCE BOARD.
Small Business Optimism
Index, August 2011 = 100
FIGURE 3
SOURCE: NFIB.
95100105110
   F  e   b   '   1   1   M  a  r   '   1   1   A  p  r   '   1   1   M  a  y   '   1   1   J  u  n   '   1   1   J  u   l   '   1   1   A  u  g   '   1   1
   S  e  p   '   1   1   O  c   t   '   1   1
   N  o  v   '   1   1   D  e  c   '   1   1
   J  a  n   '   1   2
   F  e   b   '   1   2
NFIBSmallBusinessOptimism
 
 
80100120140160
   F  e   b   '   1   1   M  a  r   '   1   1   A  p  r   '   1   1   M  a  y   '   1   1   J  u  n   '   1   1   J  u   l   '   1   1   A  u  g   '   1   1   S  e  p   '   1   1   O  c   t   '   1   1   N  o  v   '   1   1   D  e  c   '   1   1   J  a  n   '   1   2   F  e   b   '   1   2
ConferenceBoardConsumer ConfidenceU. MichConsumer Sentiment
   A   U   G   2   0   1   1   A   U   G   2   0   1   1
 
 
U
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S
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DEPARTMENT OF THE TREASURY
 
3
 
THE POTENTIAL MACROECONOMIC EFFECT OF DEBT CEILING BRINKMANSHIP
Equity Market Prices
 The S&P 500 index of equity prices fell about17 percent in the period surrounding the 2011debt limit debate and did not recover to itsaverage over the first half of the year untilinto 2012. Roughly half of US householdsown stocks either directly or indirectly through mutual funds or 401(k) accounts, sothis fall in equity prices reduced household wealth across a wide swath of the economy.Between the second and third quarter of 2011,household wealth fell $2.4 trillion. A declinein household wealth tends, all else equal, tolead to a decline in consumption spending,and consumer spending accounts for roughly 70 percent of GDP. Moreover, because agood deal of retirement savings is invested instocks, lower stock prices reduce retirementsecurity 
 – 
from the second to the third quarterof 2011, retirement assets fell $800 billion.Businesses are also affected by stock pricesbecause they rely on both debt and equity financing. When stock prices fall, investmentor other spending to expand a business ismore costly. The effects on households andbusinesses, moreover, are reinforcing. Lesscapacity and willingness of households tospend, when businesses have less incentive toinvest, hire, and expand production, all lead to weaker economic activity.
Stock Market Volatility
One common measure of volatility oruncertainty in financial markets is the
―implied volatility‖ of stock prices, measured
by the VIX. The VIX jumped around the
S&P 500
Index
1,0001,2001,4001,600
   F  e   b   '   1   1
   M  a  r   '   1   1   A  p  r   '   1   1
   M  a  y   '   1   1   J  u  n   '   1   1
   J  u   l   '   1   1   A  u  g   '   1   1   S  e  p   '   1   1   O  c   t   '   1   1   N  o  v   '   1   1   D  e  c   '   1   1   J  a  n   '   1   2   F  e   b   '   1   2
S&P 500
Index
FIGURE 4
SOURCE: S&P.
VIX Market Volatility
Index
-1020304050
   F  e   b   '   1   1   M  a  r   '   1   1   A  p  r   '   1   1   M  a  y   '   1   1   J  u  n   '   1   1   J  u   l   '   1   1   A  u  g   '   1   1   S  e  p   '   1   1   O  c   t   '   1   1   N  o  v   '   1   1   D  e  c   '   1   1   J  a  n   '   1   2   F  e   b   '   1   2
VIX
Market VolatilityIndex
FIGURE 5
SOURCE: CBOE.
   A   U   G   2 ,   2   0   1   1   A   U   G   2 ,   2   0   1   1
 
Between the second and third quarter o 2011, household wealth fell $2.4 trillion.In the summer of 2011, corporate risk spreads on BBB
-
rated corporate debt umped 56 basis points.
 

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