With Shutdown Looming, What If Congress Can’t—Rather Than Won’t—Borrow More Money?

We are now within a day of the next deadline to avert a government shutdown by midnight on January 19th. It will not be the last deadline, and if Congress does not meet it, markets will be shaken, perhaps quite badly.

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Technically speaking, a shutdown is really not that serious for the economy. Life goes on, and people in the private sector continue to go to work and produce goods and services. The public sector suffers, on the federal level at least, but in and of itself a temporary shutdown should not be anything to worry about long term. Since the first shutdown during the Reagan Administration in 1981, shutdowns have caused nothing more than tiny blips in the Dow Jones (^DJI) (NYSEARCA: DIA) and S&P 500 (NYSEARCA: SPY), so why should it be any different now?

It might not be, not yet at least, but each shutdown becomes more dangerous than the one before. Not because of anything that a shutdown would directly cause, but because of its implications for the not-too-distant future, and those implications could be a much more permanent shutdown of many government services.

Shutdowns and the threat of them are merely signs of financial stress and Congress’s complete inability to keep budgets under control. As of now shutdowns are entirely voluntary because the federal government still has the ability to keep borrowing and funding pretty much whatever it wants. But what if one day it didn’t? What if Treasury investors stopped loaning Congress more money, at least at rates low enough to perpetuate the borrowing? What if averting a shutdown was not just a political partisan issue of how much Congress allows the federal government to borrow, but instead an actual fiscal issue where Congress simply does not have the money to keep funding without limit and cuts must be made by mathematical necessity? Of course the Federal Reserve could step in again and just monetize the debt through QE, but that would risk seriously hurting the dollar.

Behind the paper-thin shutdown mask, this is the issue that is unnerving investors in a much more fundamental way. It’s just in Wall Street subconscious at this point, with news headlines concerned about the particulars of the next imminent shutdown which really, do not matter all that much in the scheme of things.

The scenario of Congress being unable to borrow rather than just unwilling might seem extreme within the current context, but it’s much more plausible than it initially seems. Reports are that China and Japan, the #1 and #2 foreign creditors of the federal government, have reduced their Treasury positions yet again last November and net buying of US mid-to-long-term Treasuries in Japan has tumbled 94.6% on an annual basis.

These declines in US debt holdings among both the Chinese and Japanese are not new. China’s foreign exchange reserves topped out at just below $4 trillion back in June 2014, nearly 4 years ago. They are now $3.14 trillion for a drop of over 20%. Japan’s reserves have been trending down slowly for the past 6 years, topping out at $1.3 trillion in January 2012. In other words, the willingness of the federal government’s top two creditors to keep lending Congress money has already been on decline for years.

One could argue that these declines are just temporary, cyclical, inconsequential. After all, Treasuries are still being sold and auctions are generally successful. But there is one more major Treasury investor that has been cutting back as well and has no plans to start buying again: the Federal Reserve.

The trifecta of Japan, China, and the Fed all cutting back simultaneously, is the real bogey man here, not a temporary shutdown. It’s only that the latter brings to mind the former, and nobody wants to think about what would happen if Congress, rather than being unwilling to borrow more, is simply unable to do so.

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