About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
The threat of a U.S. government shutdown is arriving at an especially fragile moment for the U.S. economy. Not only is a slowing economy having to cope with a surge in bond market yields and the prospect of a wave of commercial real estate loan defaults next year. It must also manage heightened Middle Eastern geopolitical tensions and a sputtering Chinese and world economy.
A U.S. government shutdown at the end of this week would greatly increase the risk of a recession next year. It would also likely invite further cuts in the country’s credit rating and would invite the bond vigilantes to send long-term Treasury bond yields higher than they already are. The yields on 10 year U.S. Treasury bonds have been above 4.6% in recent days after having briefly broken 5% in October. A shutdown would aggravate matters by raising questions about Washington’s political willingness to deal with a ballooning budget deficit and an unsustainable public debt path.
A stopgap spending bill negotiated by former House Speaker Kevin McCarthy with the Biden administration expires on Friday night. Unfortunately, there is a real risk that the government will then shut down..
New Speaker Mike Johnson has proposed an unconventional, two-stage plan to keep the government open till the beginning of next year. However, the Republican Party that elected Johnson is just as divided as it was when its members opted to remove McCarthy after the stopgap deal. A number of his party’s members have already expressed their strong opposition to his plan. Johnson can only afford to lose a tiny handful of his fellow Republicans, and Democratic support is hardly assured. It is far from clear that a shutdown can be avoided.
A government shutdown would shave 0.2% off GDP for each week that it lasted, according to Goldman Sachs. That means a shutdown of the same length that occurred in late 2018 and early 2019 would cost the economy a full percentage point of GDP. Once the shutdown ended, the economy would be expected to rebound by the same amount.
A government shutdown would be occurring just as the full effects of the past 18 months’ aggressive monetary policy tightening cycle kicks in. That is a matter of particular concern. Consumers already have to cope with 8% interest rates on their mortgage and auto loans. At the same time, some regional banks’ credit ratings have been downgraded because of their large exposure to the troubled commercial real estate sector. The last thing that the economy now needs is a blow to consumer confidence that would likely come in the wake of a government shutdown.
Meanwhile, the bond vigilantes have returned, and the credit agencies have been expressing concern about the poor state of the country’s public finances. Moody’s warned Friday that it may become the third of the three major credit-rating firms to lower the rating of U.S. debt due to political dysfunction. A government shutdown would give those rating firms every excuse to downgrade the country’s credit rating and the bond vigilantes every reason to send the 10-year Treasury bond yield back above 5% percent. That would meaningfully increase the long-run cost of financing the government’s budget deficit.
The shutdown would also be occurring at a time of heightened geopolitical uncertainty and generalized global economic weakness. The World Bank warns that in the event that the Israel-Hamas war were to spill over to the rest of the region, international oil prices could spike to $150 a barrel. It also has to be of concern for U.S. exporters that even before the world would be hit by an oil price shock, the Chinese economy is being hobbled by the bursting of its housing and credit market bubble at the same time that the European economy is on the cusp of a recession.
We have to hope that at the eleventh hour, Speaker Johnson will manage to convince his party’s hardliners about the serious consequences of any government shutdown. If he is not concerned about the economy, then at least he should be wary of a shutdown’s risks to the Republican Party’s prospects at next year’s elections. Should those factors not sway Congress, then we should brace ourselves for a hard economic landing early next year.
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