The rhetoric around raising the U.S. debt ceiling continues to soar. Janet YellenJanet Louise YellenTreasury refrains from naming any currency manipulators US could default within weeks absent action on debt limit: analysis The Hill's Morning Report - Presented by Facebook - Congress avoids shutdown MORE, the most understated Treasury Secretary in memory, told Congress that a failure to act “would be a self-inflicted wound of enormous proportions.” Federal Reserve Chair Jerome Powell, who rarely resorts to hyperbole, has warned of “severe damage,” adding the Fed could not protect the economy in the event of a default.
They are surely right that this Congress should raise the debt limit so that the United States can legally borrow the money its predecessors committed to spend. They are also right that a default by the world’s largest borrower in the reserve currency of the global financial system is a step into the unknown.
But it’s not obvious that congressional failure to act will trigger chaos on Oct. 18, when Yellen now predicts the limit will hit. More likely is a brief period of volatility until Congress does act. More damaging will be the lessons drawn by partisans on both sides who conclude they can breeze through the limit next time — and the time after that. A pattern of such behavior will deal extensive disruption to America’s financial infrastructure and undermine economic growth prospects.
Why is disaster unlikely now?
First, this default would not fall into the traditional sovereign debt categories. It’s not that the United States “can’t pay” its debts, since it can always print dollars. It’s not even that it “won’t pay,” because there is no claim in Congress that the debts are illegitimate or what lawyers call “odious.” Everyone holding America’s debt will get their money.
Second, more likely than not, the Treasury will continue to service the debts and roll over those coming due, while delaying payments on salaries, contracts and benefits, including Social Security and Medicare. That, at least, was the plan when the last debt limit showdown loomed in 2011.
Third, one of the oldest rules of investing is that if you sell something, you need to buy something. Anyone who feels obliged to sell U.S. Treasuries must either choose to hold cash, gold or buy some other government’s securities. Some investors will hold their noses and buy European or Japanese debt, but their negative interest rates make even a technically defaulted U.S. obligation more attractive for now. Other alternative markets are either too small or too risky to absorb much Treasury outflow.
For all the talk around the “full faith and credit” of the United States government, there is actually some history with default. In 1933, efforts to reflate the economy caused sharp dollar devaluation and President Franklin Roosevelt backed legislation to abrogate standard clauses in debt contracts that allowed the lender to specify repayment in gold. The Supreme Court mostly backed the law and the recovery took root.
In 2011, Congress actually missed the deadline to raise the debt limit by a few hours. The political dysfunction famously led to a downgrade by ratings agency Standard & Poor’s, but America’s borrowing costs actually fell in part because of even greater concerns about Europe’s debt crisis.
This time around, it’s not hard to imagine a few days of the Treasury juggling obligations like any household stretched at the end of the month. You pay the bank, but put off the plumber or the rent. Moreover, the outcry over unpaid Social Security checks and military salaries will surely focus congressional minds more than any hypothetical warnings about market turmoil.
But if Congress starts to regularly ignore warnings in the future when the ceiling hits, markets will not always be so benign. An even more partisan stand-off — yes, it’s possible — could see gridlock that lasts much longer. Pressure over time to pay soldiers and retirees may force the Treasury to miss interest payments. This could cause immediate problems for many accounting systems that are not even designed to record the United States welching on a debt.
By then, the search for alternative safe assets will have long since started in earnest. Cryptocurrencies will start getting a hard look from mainstream investors, while others may judge that even negative interest rates look attractive if the government behind them appears reliable.
It’s hard to estimate how America’s borrowing costs might rise, or how corrosive it would be to its growth potential, although the Fed took a stab at it. Given how much America’s political system already does to undermine faith in its currency and debt with uncontrolled deficits, escalating dollar sanctions and regular shutdowns, it’s sometimes hard to imagine a day when markets start demanding a price for all the uncertainty.
But nothing will bring that day faster than a Congress that draws the wrong lessons from a brief and uneventful default this time.
Christopher Smart is managing director, chief global strategist and head of the Barings Investment Institute. Under President ObamaBarack Hussein ObamaThe bully who pulls the levers of Trump's mind never learns US-China space cooperation is up in the air more than ever GOP infighting takes stupid to a whole new level MORE, he spent four years as deputy assistant secretary of the Treasury and two years as special assistant to the president for international economics, trade and investment. Follow him on Twitter @csmart.