Paying the Piper: Cost of the US Government Closure

The sixteen day political exercise in Washington is over.  The costs are being tallied.  There are economic and political costs that are worth considering.  

S&P estimates that the government closure will shave 0.6% off Q4 GDP's annualized rate or about $24 bln.  A Reuters poll found a consensus of 0.3% drag.  The logic apparently is that the pay will be made retroactively and that whatever activity was lost, will largely be made up quickly.  

The risk is that these estimates are on the low side.  Unlike in the 1995-1996 episode, which many are looking to for insight, none of the 13 appropriation bills were approved.  In 1995-1996 nearly half of the appropriation bills had been approved before the government closure.  That means this one is broader.  

As businesses know, re-opening after a closure entails costs as well.  Few are going to take these costs into account.  In addition, some surveys suggest that the government closure also deterred spending by many households, even without federal workers in the family.    And it is not like the US economy had good momentum going into the shutdown, unlike the 1995-1996 experience.  Much of the non-government data, like ADP, ISM/PMI, auto sales, consumer confidence and regional Fed surveys suggested that some serially slowdown was taking place.  Yesterday's Beige Book found a third of the Fed's districts reported slower activity.   

Another consequence of the government closure is that it most likely extends the monetary easing under QE3+.  While we have been inclined to see tapering next year, the market is only now coming to appreciate this.  Initially after the September disappointment, surveys suggest that a majority shifted their expectation to December.  Now in light of the fiscal drag and new uncertainty, as the mid-Jan and mid-Feb limits on spending and debt issuance will loom large at the December FOMC meeting, reduces the possibility of tapering then.    

It is not just that the Republicans failed to achieve their objectives, but many--and watch Yellen's confirmation hearings to get a better sense, are critical of quantitative easing.  The market is concluding that the government shutdown likely extends the duration of QE.   Focus is likely to shift to the March 2014 FOMC meeting for the first tapering.  

Of the costs of the shutdown, we would not subscribe to the views, like outlined in the Financial Times today, that the role of Treasuries and the dollar, as the numeraire, are at increased risk.  The key agent here, central banks, move at glacial speeds and have few compelling alternatives. 

A number of countries have long desired and sought alternatives.  Remember the demand for gold by foreign officials that ultimately forced Nixon to severe the final link between the dollar and gold was not the Soviet Union or China, but from the US European allies.   France's De Gualle was critical of the "exorbitant privilege" the US enjoyed from providing the reserve asset.  

The fact of the matter is that the US Treasury market is still the most liquid and transparent. There is little alternative for the large pools of capital, like top 10 reserve holders, and the largest sovereign wealth funds. The role of the dollar denominated instruments in the repo and collateral markets is dominant.  Many of those who would like to see the dollar and Treasury role cease do not have a compelling story of what will replace it in the plumbing of global finance. 

That said, there are political costs to bear.  That they are harder to quantify than GDP or the dollar's share of global reserves shouldn't diminish our appreciation of them.   First, momentum in the trade talks with Europe and in Asia has slowed.  Japan's Prime Minister Abe, who at first seemed skeptical of the Trans-Pacific Partnership, had gotten on-board, but had promised to conclude the talks by the end of the year.  This looks more difficult now.  A  vacuum of sorts was created when President Obama cancelled his trip to Asia. China seemed quite happy to move into that vacuum with a soft power campaign at the ASEAN meeting.  

Second, and arguably of longer lasting impact, the US's ability to project soft power has been constrained.  The self-inflicted government shutdown and threat of default is simply inexcusable for a country that had pride itself, as Reagan was fond of calling it, the City on the Hill.  The past couple of weeks have dimmed America's claim to be a  shining light.  

In fairness, America's ability to project soft power ebbs and flows.  The war in Iraq and treatment of some of the prisoners, the embarrassing reliance on outside contracts for national security both in the Iraq and Afghanistan and here at home and the unpredictable consequences, and now the purposeful closure of the government and threat of default to pursue a domestic political agenda, shows the ebb of influence is not over. 

While Americans are staring their navel (not naval), America's potential adversaries are not standing still.   If Chinese officials can announce a "big bang" of reforms at the third plenary session next month, they will be able to seize the moment. Putin's Russia is gradually able to project its influence into central Europe.   

It is difficult to see how the rot can stop.  On one hand, it could be poor developments elsewhere.  Europe and Japan are not bad at shooting themselves in the foot either, for example.  On the other hand, there might be something the US can do positively.  What is needed is the equivalent of Rubin's strong dollar policy.  

Recall that Rubin stumbled on the strong dollar policy mantra as a way to signal a break from the days of Baker and Bentsen who had threatened to use the dollar to force policy changes from German and Japan, respectively.   Although widely misunderstood and parodied, the strong dollar policy is pledge that the US will no longer threaten to devalue the dollar as a negotiating tactic.  One way to begin doing this is to reaffirm the 14th amendment to the Constitution, which declares that debt that has been properly issued cannot be questioned.  

Investors, both domestic and foreign, need to know that Jan-Feb 2014 will not turn into a repeat of what just happened.  Yet no one seems to be in a position to give this assurance.   And that alone says a mouthful.