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.