Brinkmanship refers to playing with fire. Here, the parties involved threaten as credibly as possible to go to the edge of the abyss in order to enforce their own position. The aim is to persuade the opposing party to give in.
In the current case, the Democrats and Republicans in the US are using this strategy to negotiate the national budget. This is necessary because the beginning of June marks the point at which the US can no longer take on new debt. Raising the debt ceiling requires approval in both houses of the US Congress. If neither gives in, default, or technical bankruptcy, would be the result.
Centrists reach agreement on Debt Ceiling
Democratic and Republican representatives have now reached a compromise. President Joe Biden (a Democrat) and Speaker of the House Kevin McCarthy (a Republican) have agreed to suspend the debt ceiling of 31,400 billion US dollar for two years, until 2025.
Deferral
Those government expenditures, the non-discretionary ones, are not to increase in fiscal year 2024 and are to increase by only one percent in fiscal year 2025. These restrictions do not apply to:
- defense
- social security
- state pensions
- and health (Medicare).
At the same time, eligibility criteria for poverty programs are tightened. The system of tax credits in the Inflation Reduction Act is not changed. Instead, criteria for the environmental assessment of infrastructure projects will be relaxed. According to preliminary estimates, GDP will be reduced only slightly (by several tenths of a percentage point) by the announced reduction in government spending compared with the situation without restrictions.
Residual risk remains
Both houses of Congress must approve the agreement. The House of Representatives will vote as early as next Wednesday. The Senate follows a few days after that. Because the polarization of the parties has increased, however, there is still a residual risk of non-agreement. The hardliners could therefore still overturn the centrists’ agreement.
Possible consequences of technical bankruptcy
A technical bankruptcy of the USA would lead to a massive increase in uncertainty on the financial market. This is because the yields on US government bonds act as the most important reference for many financial instruments. In addition, a US default would likely diminish confidence in the world’s most important reserve currency. Events would also likely dampen business and consumer sentiment. The likelihood of a recession would again increase.
Less liquidity on the market
The significantly reduced residual risk of a technical bankruptcy of the USA is positive for the financial markets. However, the effect is only short-term in nature. The lower growth in government spending will slightly dampen economic growth. In addition, the US Treasury will massively increase government bond issuance activity in the coming weeks. The Treasury’s account at the Federal Reserve has shrunk since May 2022 from just under $1,000 billion to currently only around $40 billion. However, the Ministry of Finance’s medium-term target is just under 600 billion. The additional issuance volume of over 500 billion will remove liquidity from the market. The effect is similar to a sale of government bonds by the central bank (quantitative tightening).
Conclusion
The agreement in the dispute over the US debt ceiling, subject to approval in the House of Representatives and Congress, is positive for financial markets. However, uncertainty about the extent of the reduced liquidity in the markets is likely to be a major market theme in the coming weeks.
In addition, the stale aftertaste remains that the financial markets will also have to deal with the effects of increasing political polarization, which may extend to political dysfunction.
For a glossary of technical terms, please visit this link: Fund Glossary | Erste Asset Management
Legal note:
Prognoses are no reliable indicator for future performance.