A point of breathless speculation by the international twitterati has been whether or not the US Congress will force the US to default on its credit obligations by refusing to raise its debt limit. Other people have dealt with what the debt limit means (if Simon Johnson is too liberal for you, there’s Bruce Bartlett), and what a congressional abrogation of responsibility would mean. The prospect that we’ll find out the practical consequences of a US “default” is a frightening one, but it’s also an interesting one from a strictly theoretical point of view.
This is basically monetary climate change. A vast vast majority of experts believe it would be catastrophic, and everyone else in the field concedes that a default would be bad but that Treasury wouldn’t allow it to happen. (See: Heritage and Cato for examples of the latter) Basically anyone who knows a damned thing about economics admits that the US no longer being able to service its debt and honor its obligations would be a bad thing™. The only difference is that some policy think tanks are telling Republican lawmakers that it’s not their fault if it happens… which has somehow translated into “no big deal” to them. So there’s a big expert consensus, a minority of dissent that is then distorted into meaning something completely different by the House Flat Earth Caucus.
Regardless, the theoretical question here is how the Rest of the World would react if the Treasury were suddenly unable to service its debt obligations.
Unfortunately history isn’t a particularly useful gauge when we consider what’ll happen in the aftermath. The closest example we have in recent memory is the Nixon Shock, but that wasn’t a question of US debt servicing but of gold convertibility. Decoupling the US from the gold standard set in Bretton Woods did noticeably impact foreign currencies (which had traded on the US’s managed standard system to hoard gold reserves), and eventually led to the inflation that created the 1970s stagflation. On the other hand, the dollar still remained a de facto international reserve currency.
The possibility exists (however unlikely) that this time the dollar could face a run similar to what other defaulting countries experienced in the late 20th century. The Asian Financial Crisis is perhaps the largest case of default in recent memory. Let’s remember that the national economies of places like South Korea took a massive hit in the order of ~30% in the wake of the currency crisis. These cases showed what happens when foreign confidence in a currency falls and investors pull out in droves. The resultant capital flight can cripple an economy by starving it of available capital and devaluing the country’s purchasing power.
The thing of course is that the US’s place in the global economy is still at a scale unrivaled by any other defaulter to date. Of the $12 trillion in global foreign currency reserves, COFER knows the currency composition of approximately $6 trillion. The dollar is by far the largest composition of these reserves, making up $3.7 trillion with the Euro trailing a distant second at $1.4 trillion. Other currencies including the Sterling and Yen are nearly rounding errors in the $200 billion range.
That is to say the vast majority of foreign currency reserves are likely in dollar denominated assets. When you then include things like treasury obligations the share rises further. This then raises the question: Would a debt ceiling failure press the world into abandoning the dollar?
The answer I think to that answer is a solid no. China doesn’t want to assume the role of world creditor. It is in fact panicking at the moment at the prospect of a US credit devaluation, (and perhaps counterproductively) demanding that US lawmakers put their house in order. The potential impact to the Chinese economy both in lost export competitiveness and in its own foreign reserve devaluation would be enormous.
The Eurozone really can’t afford to act as a substitute reserve. Or rather no one trusts them enough to act that way. US Congress might be dysfunctional, but people don’t doubt (or at least most don’t) that the US will still be here in 10 years paying back its debt obligations in dollars. There’s a very real possibility the Eurozone might not even be here in 5 years.
Finally the other potential reserves, the sterling, yen, franc, Canadian dollar, and SDRs aren’t independent enough to function as such. The first four would essentially collapse their national economies if they suddenly faced massive deflation. Special Drawing Rights at the IMF might fare slightly better, but it would devalue right along with the dollar.
So more than likely the rest of the world will swallow a technical default by the US government, selling their short-term bonds and older bonds at a reduced price, but not really factor in the possibility of a long-term default. We already see some signs of this in the bond markets, where US treasury bond volatility is still rather low. Most investors still see the US Dollar as the safest investment. Which perhaps gives us a better idea of the state of the world than anything else.
So yes, at least in the short term the world CAN ignore the signs of crazy coming from Congress and pretend that things will be paid and settled in the long run. The question is how long they’ll keep up that pretense if this becomes a common play in US politics.
Edit:
Breaking – Mon Calamari News Network’s senior White House correspondence had this to say about John Boehner’s offer of a short-term debt limit increase:
You’ve got no graphic or picture to go with this post, Nob. Might I suggest, if you can find or create one, perhaps a mushroom cloud over a dollar sign?Report
Good idea…Report
Just saw the new pic. Awesome.Report
Space awesome. Literally.Report
All you need to do is fold a dollar bill lengthwise so that George Washington’s face is hidden with the fold.Report
…Probably spent way too much time on this one…Report
Here you go, Nob:
http://www.youtube.com/watch?v=gtOZnftH0ZoReport
No, you didn’t. In fact, I want a full-size copy of that so that I can it in my screensaver slide show. It is fifty-thousand kinds of awesome. Reagan on a Velociraptor and TR vs Bigfoot awesome.Report
Sadly, I don’t think this is going to turn into a meme, Will.Report
Why are we talking about the US government being unable to service debt as if there were any chance of that?
Interest on the debt is on the order of $200 billion—well under ten percent of total federal spending. Revenues coming in are more than sufficient to cover this. The obvious thing to do is to continue making payments on the debt and make the cuts elsewhere.
Is this just a rhetorical tactic? Talk about default on the debt because people aren’t sufficiently terrified of spending cuts?Report
It was a bit of an understatement to say that revenues are more than sufficient to cover interest on the debt. Projected federal revenues for 2013 are over ten times protected interest payments.Report
Because there’s a serious constitutional and practical question of whether or not prioritizing the servicing of debt is actually legal. Further, because of the nature of tax revenues, the likelihood is that even prioritizing debt servicing would still create conditions for a technical default.
Morgan Stanley issued a report about this to investors back when the possibility was first broached in 2011.
http://www.morganstanley.com/views/gef/archive/2011/20110517-Tue.html#anchor4aa28a8e-8075-11e0-b72c-c51383242534Report
Because it’s the difference between having money and having cashflow. The bulk of receipts come in (no surprise) right after April 15, with smaller spikes in the middle of the first month of each fiscal quarter.
There are not little gnomes carting gold and silver into the US Treasury every day – the day to day accounting depends on the Fed and open market operations.Report
There are not little gnomes carting gold and silver into the US Treasury every day – the day to day accounting depends on the Fed and open market operations.
+1, to both comments, but double+1particularly this bit.Report
On April 15? How? Employers don’t hold onto withholdings all year, do they? Most people get money back on tax day.Report
http://www.fms.treas.gov/mts/mts.pdf
‘bulk’ was not the right word (and my recollections were from the bigger deficit years where the spike was more pronounced) but regardless, there’s a cyclic factor to government receipts because people that *owe* money (which includes corporations and the self-employed making quarterly payments) wait till the last possible minute – which is utterly logical and good business sense.Report
And the people that are supposed to prioritize government expenditures are the Congress, *not* the Executive.Report
You’re aware that such a thing is utterly illegal? The President lacks the power not to spend appropriated money.
Also, it’s not at all clear that the “obvious” thing to do is to make interest payments on our debt and fail to send out Social Security checks. What legal basis do you have for prioritizing payments? (a cite to statutory authority would be nice.) And how do you respond to the multiple statements from Treasury officials who say that such a thing is just not practically possible — massive reprogramming of Treasury computers would be required?
And don’t be quoting the 14th amendment back at me. What is the scope of the unquestionable “public debt”? Is it just T-bills? Says who? Who even has standing to bring such a case? Is it even justiciable?Report
What Kolohe said basically. Money comes in irregularly but goes out irregularly as well. Also there’s a question of spending priorities. Social Security payments go out on the 1st along with military pay. Are you suggesting that the Government should try and not pay social security or soldier pay in order to reserve money to pay off t-bill rollovers later on in the month? That is not only difficult, it’s also flagrantly flat out illegal. If anyone thinks treasury bureaucrats are going to risk their jobs to cover some politicians asses in congress I suspect they’re going to be sorely disappointed.Report
@north
The trouble is that anything the Treasury does will be illegal, since it will be failing to pay out duly appropriated funds. Arguably the Treasury has a superior obligation to honor debt as there is a constitutional obligation to protect the integrity of the debt.Report
Agreed James, but the -least- illegal thing to do for Treasury would be to pay out the bills as they come in with the available cash, no effort at prioritizing at all. It’s also the ‘”simplest”. The basic point is the idea that we simply will prioritize debt payment is a hugely complicated assertion and is nowhere near as likely or easy as conservatives think.Report
Plus, Brandon, your argument is basically: “Well, if I stop paying my utility bills so I can make my credit card payment and my mortgage, my credit rating won’t fall!”.
Yeah, you kept rolling over the Debt. While simultaneously failing to pay money you owe that isn’t in the form of T-bills. SS payments, contract payments, Medicare, paychecks to soldiers…..
Tell the world “We’ll pay the T-bills, but every other penny we owe is fair game to get the shaft” is gonna hurt our lending rates, because it’s a sign of fiscal craziness. Doubly so when we actually have the ability to pay, and choose not to due to some internal political slapfight.
“Let’s loan that country money! It’s not risky at all! Sure, they stopped honoring every obligation but one because, I dunno, they elected morons. I’m sure it’s a well run country where things won’t get worse!”.
Also, I understand that there is argument as to whether “Debt” refers to money owed from just lending (T-bills) or all obligations owed. Contractual payments owed. Payroll for work done. Pay for materials ordered, etc.
It’s really convenient to claim “Oh no, just the National Debt is Debt” but are you sure the world is gonna see it that way? Plus, as noted — inflows and outflows are lumpy. If Treasury gets lucky, they might be able to hoard cash and manage the lumps of T-bill turnovers, but probably not. And even then — they don’t have the authority.
Nor the ability. Treasury’s not set up to prioritize payments, even if they were legally allowed. And they system is a mess of three antiquated programming languages, and I can assure you that even IF they weren’t shutdown and on minimal staff, there’s no way on God’s Green earth even the most accomplished programming team in the world could get it ready to do that inside of six months.Report
Brandon,
In twenty days, the world as we know it now may not exist.
Investors are used to trading in risk (look at oil futures if you don’t believe me).
I know an investor or two — the ballsy kind that shorted the last bubble.
They’re out of the market right now. Too Damn Risky.Report
Good post, Nob. Our saving grace is having been as or more reliable as anyone else and just damned bigger than anyone else. We’re big enough to get away with more fishing around than other countries. But only if it doesn’t become a habit.
Maybe we’re creating an opportunity for bitcoins to become the world’s reserve currency.Report
So you’re on Townhall’s mailing list, too?Report
What’s more likely to happen (best case scenario) is we’re going to remain in our current position but be paying a noticeably higher interest rate. Of course that plays into the GOP’s whole, supposed, fiscal responsibility/reduce the debt agenda… oh wait, no it totally doesn’t.Report
I’ve seen some people say “it is damn well good you have a large military”… I think the rest of the world is rather pissed that they are so dependent on the US Economy or our actions can raise or destroy the world.Report
Pissed and taking action to reduce risk, as is in their charter, you mean.
Canadian and Australian dollars are now also reserve currency.
Breton Woods II is falling apart, just not in the shortest of terms.Report
That’s completely ridiculous. Bitcoins’ value is purely imaginary, while the dollar is backed by the full faith and credit of the United States government.
OK, not completely ridiculous.Report
The Republicans’ madness is seriously raising the question as to whether “full faith and credit of the US government” may really be a far inferior basis for value compared to “price of an arbitrary yellow metal”. If they go on this way, Ron Paul may get what he wants.Report
So this is just an elaborate scheme by the goldbugs to bring back gold-backed currency and increase poverty?Report
Lee,
I’d hardly think Koch and Scaife count as goldbugs.
They’re recaltrant reactionaries, not idiots.Report
Heh, glad to get that line out there and give everyone the chance to riff before Roger’s No Snark November policy takes effect.Report
That’s a REALLY bad linked explanation of the debt ceiling. If I didn’t know better, after reading that I’d conclude the Debt ceiling is what prevents the President from spending whatever he wants.
In fact, I’d probably conclude the President actually set the budget and Congress was uninvolved and created the Debt Ceiling to reign in the President’s power of unlimited spending.Report
I’ve replaced it with a link to Simon Johnson’s excellent piece.
I’m actually disappointed Investopedia’s definition is so awful….Report
Check out Conservapedia’s.Report
…I needed that laugh, thanks.Report
@nob-akimoto, just wanted to make sure you (and other OTers) saw Bruce Bartlett’s column on the debt limit; an excellent historic overview and primer on the risks at hand; a good conservative view to balance Simon Johnson’s.Report
Thanks. Including it in the updated list.Report
Just wanted to add my voice to the chorus of praise, both for the totally space awesome featured art and for the content of this interesting and informative post as well.Report
Thank you for this, Nob.Report
Kind of feel like doing a follow up post describing how the US could engage in massive economic warfare by defaulting, using Spy vs Spy graphic with Obama and XiReport
Foreign countries that have tried to ignore the us and not use dollars often get their countries invaded: libya, iraq, or get sanctions, iran.
Regardless, I try to ignore congress as much as possible.Report