Before we begin, let it be said that the looming possibility of the U.S.’s default on its own debt is a not-insignificant issue. Let it also be said that the U.S. government may be unwilling to pay interest on its multi-trillion dollar publicly-held debt as of mid-October, and that this carries substantial risks. And, finally, let it be said that this is something we should most definitely avoid.
The potential for a default — however self-inflicted — raises the specter of just about every bad thing economically that you can imagine. And there have been no dearth of voices drawing attention to a variety of doomsday scenarios. The U.S. Treasury Department, which is not normally known for its hyperbole, just issued a report warning of a global economic depression should the U.S. default: interest rates will skyrocket, financial markets will panic, and the global financial system will lose one of its only bastions of predictability and stability.
Five years ago, Lehman Brothers was allowed to fail because of a complacent and erroneous view that its effect would be limited to little more than a market disruption. Today, the prospect of a U.S. default is met with the opposite of complacency. The only voices expressing skepticism that a default would be catastrophic are the very Tea Party ultras whose burn, baby, burn mantra appears to welcome the possibility of an implosion. How else to purify and rebuild a corrupt system?
There’s ample reason to believe that a default will sever once and for all the gossamer threads of trust and stability that sustain not just the U.S. but the global economic system. But it is worth considering that it may not have quite the feared effects, especially because it is such an unprecedented possibility that no one can predict what its outcome might be.
Let’s hypothesize that the next weeks are frittered away as the White House and Congressional Democrats refuse to negotiate on anything until the Republicans allow the government to operate and the Treasury to borrow. Let’s say the drop-dead date of October 17th is reached and the Treasury finds itself unable, logistically, to prioritize the tens of millions of payments it has due. Let’s imagine that it misses an interest payment on the debt, which is the definition of a default. What then?
The speculation is that interest rates will spike dramatically, equity markets will crater, funding markets for daily credit will come under immense strain, and the global financial and commercial system will teeter. That is akin to what happened in the fall of 2008, and the concern is that this coming crisis will unfold the same way. It’s very easy to see that happening. Less clear is what comes after and when, and that is where we may be making a reverse-Lehman mistake and overestimating the catastrophic effects.
To begin with, there is currently just a tad under $12 trillion of debt held by the public, out of nearly $17 trillion of total U.S. debt. That is a considerable portion of the global bond market, comprising between 10 and 20 percent of all bonds issued globally depending on how one calculates. And some significant portion of that global market is priced relative to the price of U.S. Treasuries, which remain one of the few highly-liquid, highly-rated, and easily bought and sold instruments of credit in the world.
The size of the market for U.S. bonds is one reason for the high level of concern about what would happen if these supposedly safe and secure instruments were suddenly shown to be not so safe and not so secure. But that size also means that U.S. bonds are not like any other financial instrument. Faced with a default of a normal bond, investors shy away. They demand to be paid more for higher levels of risk. They sell what they have. Faced with a default of U.S. bonds, however, people are running towards them.