Worries about U.S. shutdown pales to potential damage from debt ceiling crisis

OTTAWA – The border is still open, trade is still being conducted and stock markets have mostly shrugged off the first days of the partial shutdown of the U.S. government.

But as far as disruptions and cataclysmic economic shocks go, experts and business leaders agree the current self-created crisis in the U.S. Congress would pale next to the fallout that would occur two weeks from now if the ongoing political dysfunction leads to the first default in U.S. government history.

Failure to raise the debt limit ceiling on Oct. 17 — the next congressional self-imposed spending deadline — would in essence impact the U.S. government’s ability to keep paying its bills. The resulting fallout would almost certainly roil financial markets and reach the shores of virtually every world economy and certainly that of neighbouring Canada.

But the fact is, nobody knows how serious it could get, says John Manley, head of Canada’s most influential business lobby, the Canadian Council of Chief Executives, because it’s never happened before.

“This absolutely would be much more serious than the shutdown,” says Manley. “You’ve got the risk of a loss of confidence in the global financial system. Hold onto your hats, because the consequences are going to be unpredictable.”

Two recent events give a clue as to what could occur, and neither is reassuring.

The most recent was a debt ceiling controversy that occurred in August of 2011. At the time, an 11th-hour solution averted the crisis, but the incident was enough to shake market and business confidence leading to a subsequent slowdown in economic activity.

The example is not perfect as the debt issue followed two previous shocks — the Japanese tsunami and a flare-up in the financial crisis in Europe — which are missing from today’s equation.

The earlier event occurred in late 2008 when the President George W. Bush proposed a bailout of Wall Street following the Lehman Brothers bankruptcy.

Despite grousing among hardliners in Congress, markets assumed legislators would swiftly approve the bill, known as TARP, because the consequences were so dire. Yet Congress rejected the law at first, which caused a market crash, forcing lawmakers to change their minds two days later.

Given the history, most analysts still do not believe U.S. politicians will be willing to risk a new debt crisis, or at least not one that lasts long enough to plunge the U.S. back into recession.

Still, economists say the uncertainty and never-ending fiscal brinkmanship in Congress is already damaging the economy, making businesses think twice about committing to new investments and hiring.

Further, failure to avert the crisis this time might shake confidence longer term, they say, as the U.S. political system proves once again incapable of putting aside partisan differences even at the expense of mutual economic well-being.

“Unfortunately, this is coming at not the nicest time for Canada,” says Michael Gregory, a senior economist with the Bank of Montreal (TSX:BMO).

“We’re kind of waiting for the U.S. so we can ride those coattails. If the U.S. suffers a negative economic impact for a week or two or three, or hurts confidence for a month or two or three, then we will feel the impact. If they are buying less cars because they are worried, Canada will sell fewer cars.”

Strangely, analysts are divided on how the Canadian dollar will be effected, although almost everyone agrees there will be one and it might be dramatic.

On the one hand, uncertainty and economic weakness would logically lead to a devaluation of the greenback and an appreciation in the relative value of the loonie, which is supported by a stable economy and relatively low government debt.

But markets are at times perverse. Money flight could head to the traditional safe haven of U.S. treasuries — as it did following the U.S. financial crisis of 2008 — leading to a downgrading in the Canadian currency.

TD Bank (TSX:TD) chief economist Craig Alexander cautions that failure to raise the debt ceiling will not result in the U.S. government defaulting on its debts to bondholders.

What is more likely to occur is that the U.S. will prioritize the payment of its bills and put servicing the national debt at the top of the list. The people who have to worry most are the tens of thousands of suppliers who contract with the government and, of course, public servants.

Still, even partial defaults will likely cause the rating agencies to downgrade U.S. debt simply because the risk of a real default, while still unlikely, has increased, Alexander adds.

“It is evident that fiscal policy and fiscal policy uncertainty in the United States has been restraining economic recovery,” he said. “So we might not even fully appreciate at this time the long-term consequences of what’s happening in Washington.”

The problem for Canadians is that they are virtually powerless to influence events south of the border, or to protect themselves from the fallout.

“The solution to this is entirely in the hands of Congress,” said Manley.

On the government shutdown, Canadian Chamber of Commerce president Perrin Beatty says Ottawa must closely monitor trade flows and the border for any signs of delays, and alert U.S. authorities. He says he knows the Canadian Embassy is watching the issue, although there have been no early reports of disruptions.

“Obviously the level of concern will grow the longer it goes on, but now it’s early,” he added.

As a last resort, the Bank of Canada and Ottawa have room to stimulate the economy through further cuts to interest rates and additional government spending, but Alexander said that would only occur in the event of a U.S. recession, which is still highly unlikely.

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