By Zachary Karabell
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 ultra 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.
Bond yields have actually fallen in the past weeks, suggesting higher demand. Searching for safety in risky times, investors — and that means not just traders on Wall Street but large asset managers, investment advisors, pension funds and foreign governments — turn to the one thing that has been safe, U.S. bonds, even as the one thing that looks to be increasingly less safe is…U.S. bonds.
Now you could say that this is a sign of additional risk, because it flies in the face of common sense. Why buy the very thing that looks most imperiled by the political crisis in Washington? Because U.S. bonds are not like any other financial product.
Yes, these bonds are seen as safe, which is why they are so attractive. But that's a dangerous cliché. The lure of safety is one of the great risks in current financial markets.
Nevertheless, the United States remains fully capable of meeting its debt obligations regardless of a default. The fears over Greek sovereign debt two years ago or Latin American debt in the 1970s was that those economies could not meet the burden of interest payments and could not turn to international financial markets for credit. They were indeed insolvent.
What's going on in the United States has nothing to do with insolvency. This would be a default of choice, not of necessity. The reason why U.S. bonds are so attractive may in part be a false sense of security, but it is also a reflection of genuine U.S. economic strength compared to almost anywhere in the world. The output and consumption of the United States is largely not a product of the U.S. government, and would not radically change because that government made the monumentally odd and foolish calculation to default on debts that a small portion of the government does not respect.
Even with a dysfunctional government, it's a good bet that the U.S. will generate sufficient growth compared to the rest of the world. The amount currently required to service the debt of the U.S. government is in fact lower than at any point since the 1980s, because interest rates are so low. And there is no question that the economic output of the country allows for that debt to be serviced, regardless of whether Washington is functional.
That is why the consequences of a default may not be what we imagine. Yes, such an event would likely trigger a financial market panic, and yes, rates would spike in response, forcing a series of consequences as those holdings were marked down to reflect changed market prices. But very quickly, another reality could take hold: because the crisis is purely self-inflicted, the ability of the United States to generate sufficient output to meet its obligations would not have been altered.
What would also quickly become clear is the disjuncture between government on the one hand and "the economy" on the other. For now, we have a tendency to conflate the two, and assume that government is either essential to economic growth (a classic Democrat stance) or inimical to it (a typical Republican approach). A default, or even the threat of one, might expose the degree to which government is one factor among many in the complicated world of economic affairs, and not nearly as powerful a factor as enemies or advocates believe.
It would, of course, be foolish to rest on the argument above and dismiss the risks. But it is wrong to assume the worst just because the worst is so easy to assume. Tea Party nihilism will lead us nowhere good, but the conviction that the actions of Washington are the primary pivot of both the global financial system and American economic vitality is both incorrect and limiting. If any good comes from this crisis, the waning of that conviction would be welcome indeed.