Can We Believe Geithner on Debt?

Don’t panic.

Timothy Geithner
Photo by: Pete Souza
Timothy Geithner

That, in a nutshell, was the soothing message of Tim Geithner, US Treasury secretary, as he did the rounds of Washington on Thursday, the day after President Barack Obama called for a fiscal reform deal, together with $4,000 billion cuts.

Never mind that President Obama’s plan sparked a furious response from Republicans; this could further rile Tea Party politicians who are so opposed to letting the US government raise its debt ceiling that they are threatening to force a US bond default this summer.

If Mr Geithner is to be believed, bond investors should know that this default chatter is just part of the normal political process.

“You see a lot of confidence in markets that the American political system will be able to get on a path [to resolving the fiscal problems],” he told the Financial Times on Thursday.

“The markets believe that our problems are manageable and our system will solve them. There is no conceivable way that Congress would take the risk [of forcing a default].”

Can this reassuring patter be believed? Up to a point, m’lud.

On the surface, the current behaviour of the bond market appears to support Mr Geithner; though the government came to the brink of a shutdown last week, due to fiscal brinkmanship, 10-year Treasury yields were on Thursday trading at just 3.48 percent.

There is little sign of foreign selling; bond auctions remain well covered.

However, what is less visible – and more ominous – is that, behind the scenes, some large asset managers and banks are already discreetly debating contingency plans, not just for a spike in yields but also a technical default.

“There are all kinds of ‘what if’ scenarios being discussed,” one senior banker confesses.

And while such “what if” scenarios are still viewed as extreme, the big question dogging Mr Geithner now is what exactly does Washington need to do to maintain this sense of calm?

Is it enough for Mr Obama to simply call for a $4,000 billion plan? Would a deal on the debt ceiling be enough? Or is a tangible fiscal plan required? Where, in other words, does the $14,000 billion (debt ceiling) sentiment tipping point lie? The honest answer, of course, is that nobody knows; or not unless that tipping point is reached.

But some seasoned heads in the White House think that there are now three crucial variables to watch: first, the “acknowledgement” issue (namely whether politicians recognise the fiscal problem); secondly, the “process” question (whether there is a constructive debate); and thirdly, the “plan” (namely whether there are credible proposals on the table).

If two out of three of these items are on the checklist, the argument goes, investors will remain reassured.

If not, trouble looms.

As checklists go, this seems quite sensible to me. And on the first item – namely the “acknowledgement” question – there has been progress.

In late 2010, when Mr Obama’s bipartisan fiscal commission first issued a report on the debt, the White House hoped that tough fiscal debates could be delayed until after the 2012 election.

That thinking, however, has now changed.

That is partly because voters are becoming focused on the issue. However, recent reports from the International Monetary Fund, and revelations that Pimco has taken a negative stance on Treasuries, have also concentrated minds.

On the second point on this list, though, the score is more mixed. Late last year, the bipartisan Simpson-Bowles fiscal plan provided one sign of constructive engagement.

Another encouraging sign of sensible process can be seen in a similar fiscal report being prepared by a so-called “Gang of Six” Democrat and Republican senators.

However, Mr Obama’s speech this week may – ironically – have actually undermined this constructive debate, by alienating Republicans.

Sensible dialogue remains the exception, not norm. And that makes it that much harder to produce the third item on the checklist: a credible fiscal plan.

Optimists in Congress insist that the main players in the fiscal debate now accept that any eventual plan “will look something like Simpson-Bowles, plus or minus twenty percent,” as one leading senator says.

After all, both sides are targeting cuts in the $4 trillion-$5 trillion range. However, the two sides remain bitterly divided about the fiscal mix.

Thus, there is almost “no chance” of any tangible fiscal plan being agreed on this summer, Henry Waxman, Democrat Congressman, told the FT on Thursday; he thinks this must wait two years.

Now, that long delay may not be entirely disastrous for market sentiment if the first two factors on that checklist are in place.

At the very least, Congress must have enough “process” in place to raise the debt ceiling. But just acknowledging the problem is clearly not enough.

Little wonder that those banks are preparing contingency plans, even amid the reassuring rhetoric.

Mr Geithner now has his work cut out.