It seemed likely that in coming weeks that the US government might go into shutdown. Shutdowns occur because of "divided government." In the US, the Peoples' House, or the House of Representatives, now has a majority of members from the Republican Party. The President and the majority in the Upper House, the Senate, are from the Democratic Party.
At the end of last year, the previous Democratic legislature passed what was called the 'Inflation Reduction Act.' In reality, this piece of legislation was entirely the reverse. This legislation increased the budget deficit between 2% and 3% of US GDP in each year over the period to 2027. In a situation where the GDP gap (the extra room for growth) is less than 1%, these deficits are highly inflationary.
This year the current Republican legislature has passed a debt ceiling which increases annual debt by 1% less than increases in inflation. This does not provide for the issue of enough debt for the government to finance the big budget deficits required by the 'Inflation Reduction Act'. Treasury Secretary Janet Yellen says that the US Treasury will not have enough funds to finance the spending under the Inflation Reduction Act from the 1st of June 2023. If there is no agreement between the two sides, then the US government will begin to shut down.
Many commentators believe that this government shutdown means that the US government will not be able to honour payments owed for US Treasuries. This means the US Treasury bonds will default. In coming paragraphs, we will explain why this default has not happened previously and why it will not occur on this occasion.
There have been ten US government shutdowns since 1980. There were five between 1980 and 1990. In Table 1, we show the five which have then occurred between 1995 and the current day. For each shutdown we show when it happened, how many days it continued, and how many workers were furloughed. The last statistic is most interesting.
These shutdowns occurred because the US government did not have enough money to finance all its activities. Still, in none of these earlier shutdowns did US Treasuries default. The government continued to pay all the interest payments due on US Treasuries and all principle due upon maturity. What happened instead was that public sector employees were progressively 'furloughed'. This means that public sector employees were put on leave without pay until agreement between the two sides of divided government could be reached.
We can see from Table 1 that the amount of time that it took for an agreement to be reached varied from as little as five days to as many as 35 days. The result of this period of shutdown meant that there were large numbers of public sector employees who were furloughed. The number of public sector employees on leave without pay varied from 284,000 in 1995-1996 to 800,000 in 2013. These employees resumed work and got their back pay when agreement between the two sides of divided government could be reached.
Why is it that in all these cases that the principal and interest of US Treasuries continued to be paid? The answer goes all the way back to the man who invented the US Treasury bond in 1789. His name was Alexander Hamilton. Yes, he is the same man that is the subject of the hit musical 'Hamilton'.
In July 1789, Hamilton persuaded the US Congress to pass the bill which created the US Treasury bond. These bonds were then used to buy all the State government debt that was required to finance the revolutionary war. The Congress then had to create a source of income to pay for the debt and principal on those Treasury bonds. As a result, they passed in 1791 the Tariff Act of 1791. This Bill repealed the duties that the British had placed on imported spirits and levied instead a US import tariff on spirits and upon spirits distilled in the United States.
The proceeds of these levies were to be devoted to paying the income and principal due on these Treasury bonds. In short, US Treasury bonds had, from their beginning, a First Right of Payment on taxation income levied by the United States from the very beginning of the United States taxation system.
In practical terms, this first right of payment for US Treasury bonds continues (see footnote). When the government shuts down, US Taxation revenue is used to pay the money owed on US Treasury bonds first and US government employees second. This system has continued from 1791 until this day. This is why US Treasury bonds never default.
This report was prepared as private communication to clients of Morgans and is not intended for public circulation, publication or for use by any third party. The contents of this report may not be reproduced in whole or in part without the prior written consent of Morgans. While this report is based on information from sources which Morgans believes are reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect Morgans judgement at this date and are subject to change. Morgans is under no obligation to provide revised assessments in the event of changed circumstances. This report does not constitute an offer or invitation to purchase any securities and should not be relied upon in connection with any contract or commitment whatsoever.
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