I Don't Know What Will Happen If We Default, and I Don't Want to Find Out

The CEO of Pimco, the world's largest bond investor, explains why breaking through the debt ceiling could create "a huge global mess."
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Reuters

Having shut down the government without causing disastrous damage to the nation’s economy, some Republican lawmakers are now playing Russian roulette with the debt ceiling. They seem comforted by the notion that, with the exception of some general warnings, few economists have been able to demonstrate convincingly why failure by Congress to raise the debt limit would be such a disaster. Indeed, despite all the political wrangling, there are is as yet no consensus on the potential hit to growth, jobs and income.

This comfort could quickly dissipate if these politicians were to understand better the plumbing of the domestic and international monetary system. And, like any major plumbing issue, a previously overlooked and downplayed area can quickly create a huge big mess that is difficult to clean up and leaves structural damage.

The context is quite well known by now. According to the U.S. Treasury, the country will hit its debt ceiling on or around October 17th. If Congress does not act to lift the limit, the Administration would be faced over the next days and weeks with the difficult task of trying to prioritize and delay payments in the context of a limited cash reserve cushion, lumpy revenue collections, and less-then-adequate expenditure flexibility.

If the Congressional impasse is prolonged, the U.S. would face the risk of accumulating some types of payments arrears, including potentially down the road interest and principal payments on bonds held by residents and foreigners. In such circumstances, the U.S. would be defaulting not because of a problem with its financial ability to pay but, rather, due to the lack of political will to do so.

Unlike the government shutdown where economists have put forward broadly consistent estimates of the economic damage – an initial hit to quarterly GDP of about 0.1 – 0.2 percentage points, the bulk of which would likely be both temporary and reversible – the profession is all over the place when it comes to the impact of a debt default. This is understandable.

There are no analytical models that handle well the impact of a U.S. sovereign default. As such, running economic scenarios is very challenging. There are also no historical precedents to go by. And even if one could trace the exact impact on government outlays and payments prioritization, it is virtually impossible to quantify the response of consumer and business confidence, let alone the reaction of the rest of the world that operates in a dollar-anchored global monetary system.

This lack of specificity should not lead to complacency. Indeed, if you want to get a handle on the potentially catastrophic effect of a default on the country’s well-being, you need only consider how the pipes of the global system are organized and function.

Being the most powerful and financially sophisticated economy in the world, the U.S. is at the core of the international monetary system; and U.S. Treasury securities are at the core of the core.

Domestically, Treasuries are used as a store of value and, along with cash, constitute the largest portion of the precautionary holdings of individuals and companies. They provide the operational benchmarks for a wide range of other securities, be they mortgages or corporate obligations. They are the most important form of collateral used in both simple and sophisticated financial transactions. And they anchor the very notion of financial stability and soundness.

Outside America, many foreign individuals, companies, governments and central banks rely on U.S. Treasuries for these uses too. Indeed, they have essentially delegated an important part of their financial intermediation process to the U.S., and reasonably so. After all, our country issues the world’s reserve currency and provides the deepest and most liquid financial markets, and one supported by a solid rule of law.

Now, and this is critical, this whole construct is based on the assumption that the core of the system will act predictably, responsibly and rationally. If this assumption proves faulty – which is what would materialize from a Congressional refusal to lift the debt ceiling in a timely manner – the rug would be pulled from the critical underpinning of daily financial transactions.

A U.S. debt default would result in multiple sovereign and corporate credit downgrades, widespread disruptions to collateral exchanges, and the triggering of disruptive legal clauses in a wide range of contracts. As hard as they try – and they would try very hard – central bankers from around the world would find it difficult to fully compensate by stepping in as reliable counterparties. The result would be cascading failures in financial markets that would meaningfully disrupt economic activities.

In such circumstances, there would be a major flight into cash, a rapid decline in consumer spending, and a virtual sudden stop in business investment. With intricate cross-border financial networks also in play and transmitting the disruptions widely, it would only be a matter of time before a world falling quickly into recession would also face the even more frightening threat of a global depression.

Indeed, all this sounds quite similar to what happened five years ago when the disorderly collapse of Lehman Brothers disrupted the payments and settlement system. And even though we still live today with the negative aftermath of that global financial crisis – including stubbornly sluggish economic growth, unacceptably high unemployment, and alarming long-term and youth joblessness – the world was able back then to rely on large public balance sheets to act as mitigants to a great depression.

This time around, the world has fewer spare tires. Accordingly, the economic hit to growth and jobs would be much harder, the duration longer, and the recovery even weaker and more protracted. Also, this time around, the rest of the world would work much harder to reduce dependency on what could become an overly unpredictable U.S.-centric global financial system. With that, our global standing and political influence would suffer, further undermining our national interests and national security.

Today’s deeply polarized Congress, combined with a particularly disruptive and driven minority, is naturally tempted to play a game of chicken with whatever attracts national attention. The government shutdown is an example of this. Yet, in relative terms, its impact is small when compared to the breakage that would result if the debt ceiling were not lifted.

Have no doubts, politically-induced disruptions to the plumbing of the global financial system would create a huge global mess. And the negative consequences would be felt by both current and future generations.

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Mohamed A. El-Erian is CEO and co-chief investment officer of Pimco, the world's largest bond investor, and author of When Markets Collide.

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