The Ultimate Nightmare: American Default
For the first time in seventeen years, the U.S. government has shut down over a budgetary dispute. Not surprisingly, with both sides refusing to move from irreconcilable positions, metaphors of trench warfare are being used freely. But this dispute is more reminiscent of the ‘Phoney War’ of 1939 and 1940. The real conflict will come on or a little before October 17, when the U.S. government runs out of expedients to avoid issuing new debt. At this point, it will be necessary either to raise the ceiling on government debt or to risk unknown and potentially catastrophic consequences.
But why is the debt ceiling much more important than a shutdown of the government?
The shutdown is damaging, to be sure, but it is confined to ‘nonessential’ functions, with the term ‘essential’ being defined fairly broadly. If a shutdown were sustained for a month or more, the consequences would be severe, but the arrival of the debt deadline will render this question moot (unless, the Republicans decide to raise the debt ceiling but persist with their demands on the continuing funding resolution).
The risks associated with a failure to raise the debt ceiling may be seen by considering the worst-case scenario: a formal default on U.S. government debt. This is highly unlikely. Until recently, however, it was inconceivable. The near-miss on the debt ceiling vote in 2011 led Standard & Poor's to downgrade U.S. government debt from AAA to AA+, saying in effect that default was a possibility. A failure to raise the ceiling, even for a few days, would almost certainly lead to further downgrades from S&P. The other ratings agencies, Moody's and Fitch, would need to do likewise.
If default is possible, what would it entail?
Even a short-lived default would throw global financial markets into chaos. Most directly, it would mean that the defaulted securities could not be delivered as collateral for financial transactions. Although, presumably, the default would apply only to Treasury securities with payments falling due in October, markets aren’t set up to distinguish between good and bad Treasuries, so they would be thrown into chaos. In addition, Credit Default Swaps on U.S. bonds would be triggered, with unpredictable consequences. Current estimates suggest that the U.S. CDS markets is relatively small: ‘only’ around $23 billion, but with other financial markets facing a rush for liquidity, that could be enough to bring down financial institutions on the wrong side of these trades.
To sum up, in the words of Cardiff Garcia of the Financial Times “an actual debt ceiling breach is essentially Armageddon.” If the deadline for a debt-ceiling increase is passed, such a possibility becomes real.
And, every time the possibility arises, the likelihood of the real thing becomes larger. Any resolution of the current crisis that leaves the way open for similar standoffs in future will ensure further downgrades of U.S. government debt and undermine financial systems based on the assumption that Treasury bonds are riskless assets.
Since a default on U.S. government debt would be utterly disastrous, it seems unlikely that it would actually happen, at least this time. Once the current expedients are exhausted, President Obama would have two options available.
The first would be to repudiate other legal obligations, such as Social Security payments, in order to provide funds to service debt. This would almost certainly cause severe economic damage, as well as a potential legal and constitutional crisis. Given a decision not to make legally obligatory payments, the President would be operating outside the law and therefore effectively unconstrained in choosing which payments to withhold. He could, for example, stop payments to districts with Republican representatives.
The second possibility is to disregard the debt ceiling, most likely by declaring the relevant sections of the Budget and Accounting Act of 1921 to be unconstitutional (an alternative scheme involves directing the Treasury to mint a platinum coin of arbitrary value, but this seems too ridiculous to be considered seriously). Such a declaration would certainly be subject to legal challenge, but the courts might well decide to steer clear. More importantly, it would be open to the Republican House to go back to the option of refusing to pass a budget or continuing resolution.
Even with all these risks, Obama seems likely to stand his ground. Any concession, even the smallest, will legitimate the idea that the threat of default is a legitimate weapon of party politics, to be used in support of any strongly held policy objective. Sooner or later, this idea will lead to disaster.
The potential benefits of an outright win for the President are huge, and not merely in partisan political terms. If the default risk represented by the debt ceiling is removed once and for all, confidence in U.S. assets will increase substantially. The underlying budgetary position of the United States is much better than is commonly supposed and could be improved further in the event of a return to the regular budget process that has been in limbo for the past fifteen years.