An Unplanned Effect of a U.S. Default?
-- Posted by Neil H. Buchanan
In my first column for the new Verdict: Legal Analysis and Commentary legal magazine, published today, I return to the intensifying battle over the federal debt limit. I extend the analysis from my series of Dorf on Law posts on the topic back in April and May (here, here, here, here, here, and here), arguing that the Obama administration must take the politically risky position that the debt limit statute is unconstitutional, in order to prevent an endless series of debt-limit-induced political crises.
I concede, however, that even if the debt limit is nullified, the new world of budget-induced brinksmanship will continue largely unchanged. The regular budgeting process, currently a once-a-year event, can be turned into an ongoing circus, with threats of government shutdowns on a daily basis, if the House Republicans choose to go that route. Even so, taking the possibility of a federal default off the table would remove at least the most dangerous weapon from the political theater of war.
Here, I will discuss what would happen if there were a debt default, from a slightly unusual perspective. Rather than thinking about higher interest costs for the federal government, or financial contagions that are likely to send the global economy into a tailspin, it is interesting to think about what would happen if a federal default did not create an economic catastrophe. Instead, what would happen if U.S. Treasury securities (the building blocks of federal debt) simply lost their status as the safest asset in the world?
Different financial assets pay different interest rates. Rates differ because of a variety of differences in the assets themselves, including term (a one-month security usually paying a lower annualized rate of return than a 30-year security) and various types of risk. If investors are worried that inflation will erode the value of their returns, for example, they will require a higher interest rate than if inflation is expected to be zero. Similarly, differing risks of default (the failure to repay principal or interest, or both) will result in different interest rates for different assets.
The unique status of U.S. Treasury securities (aka Treasuries) is based on the impossibility of default. While investors require higher interest rates to compensate for the risk that, say, a loan to a start-up company will never be repaid, the U.S. government is able to pay lower interest rates on Treasuries because there has never been any perceived risk of default.
This perception of safety is not based only on the track record. The federal government, unlike any other bond issuer, has the ability to create the very dollars that it needs to repay its loans. While that ability can be abused, creating the possibility of inflation, investors know that the federal government can at least pay the principal and interest on every dollar that it borrows.
Because Treasuries have no default risk, they have become the equivalent of cash in financial transactions, and on the balance sheets of banks, corporations, pension funds, and individuals. When we talk about a company paying "$10 million in cash" in one deal or another, for example, that generally means not greenbacks but ten million dollars worth of Treasuries. People and institutions (including foreign citizens, corporations, and governments) trade Treasuries as cash-equivalents because the market in which Treasuries are traded is large and well-regulated, allowing all sides to a transaction to deal in a well-understood and safe medium of exchange.
What if Treasuries were no longer available to serve that role? In the late 1990's, when various factors created a series of large federal budget surpluses, there was a genuine concern about the disappearance of Treasuries as a basis for financial transactions. If the entire national debt had been paid down, there would have been no more Treasuries in circulation. This possibility was openly discussed by economists and financial planners at the time, and the need for a deep market in Treasuries was one of the factors that former Fed chair Alan Greenspan invoked when he endorsed the 2001 Bush tax cuts. Without those tax cuts, he reasoned, the global financial system would lose its essential lubricant.
At the time, skeptics suggested that the disappearance of Treasuries might not be a big deal. Arguing what amounts to a dependence/use distinction, they said that the financial markets would find a (nearly?) risk-free alternative, or they might even invent one (perhaps a synthetic security backed by a basket of currencies). Recall that this was the time when financial engineering was viewed as an unalloyed boon to society, making such an argument at least plausible.
We never saw the day when the Treasury market became so shallow that it affected Treasuries' status as the equivalent of cash. (We did, however, get some sense of the problems that might arise. When the Treasury stopped issuing 30-year bonds, those securities became scarce, and that market stopped acting in "normal" ways.) U.S. and global financial planners have continued to use Treasuries as their basic building block.
One of the stated goals of the new majority in the House, of course, is paying down the national debt. While I am deeply skeptical that they would ever do so -- because they would be too tempted to cut taxes every time they cut spending, no matter how deeply they cut spending -- it is at least a matter of professed faith among anti-government politicians and activists that the federal government should not owe any money to anyone.
If one is unhappy about the very existence of federal debt, it would be useful to undermine the national debt's positive uses. If Treasuries lose their status as cash-equivalents, a future Greenspan could not argue that Treasuries are an essential element of a healthy financial system. Therefore, a major advantage (from the anti-government perspective) of the prospect of a U.S. default is that it would make a Treasury bond just another security, no different from securities issued by General Electric, the State of Ohio, or the government of Moldova. The ultimate disappearance of Treasuries would, therefore, not disrupt financial markets. (The disruption would come when the U.S. defaulted on its obligations in 2011, not when Treasuries finally disappeared some years later.)
I have no reason to suspect that this is a conscious conspiracy, or even that anyone drinking tea has even thought about this possibility. Whereas the Bush years seemed to be a sustained and deliberate effort to prove that government could do nothing right and should be distrusted, undermining the financial usefulness of Treasuries would seem to be merely a happy side-effect for Speaker Boehner and his allies. If they continue on their current path, they might soon be able to argue that Treasuries have become too dangerous and volatile, making it important to take them out of circulation by paying down the national debt.
Again, I do not believe that the people threatening to force a default would ever actually pay down the national debt. Still, it is interesting to observe that their current strategy necessarily involves risking the credit-worthiness of the United States -- a risk that, far from being the disaster that most of us expect, might deliver a delightful dividend to those who profess not to be concerned about the consequences of a possible U.S. default.
In my first column for the new Verdict: Legal Analysis and Commentary legal magazine, published today, I return to the intensifying battle over the federal debt limit. I extend the analysis from my series of Dorf on Law posts on the topic back in April and May (here, here, here, here, here, and here), arguing that the Obama administration must take the politically risky position that the debt limit statute is unconstitutional, in order to prevent an endless series of debt-limit-induced political crises.
I concede, however, that even if the debt limit is nullified, the new world of budget-induced brinksmanship will continue largely unchanged. The regular budgeting process, currently a once-a-year event, can be turned into an ongoing circus, with threats of government shutdowns on a daily basis, if the House Republicans choose to go that route. Even so, taking the possibility of a federal default off the table would remove at least the most dangerous weapon from the political theater of war.
Here, I will discuss what would happen if there were a debt default, from a slightly unusual perspective. Rather than thinking about higher interest costs for the federal government, or financial contagions that are likely to send the global economy into a tailspin, it is interesting to think about what would happen if a federal default did not create an economic catastrophe. Instead, what would happen if U.S. Treasury securities (the building blocks of federal debt) simply lost their status as the safest asset in the world?
Different financial assets pay different interest rates. Rates differ because of a variety of differences in the assets themselves, including term (a one-month security usually paying a lower annualized rate of return than a 30-year security) and various types of risk. If investors are worried that inflation will erode the value of their returns, for example, they will require a higher interest rate than if inflation is expected to be zero. Similarly, differing risks of default (the failure to repay principal or interest, or both) will result in different interest rates for different assets.
The unique status of U.S. Treasury securities (aka Treasuries) is based on the impossibility of default. While investors require higher interest rates to compensate for the risk that, say, a loan to a start-up company will never be repaid, the U.S. government is able to pay lower interest rates on Treasuries because there has never been any perceived risk of default.
This perception of safety is not based only on the track record. The federal government, unlike any other bond issuer, has the ability to create the very dollars that it needs to repay its loans. While that ability can be abused, creating the possibility of inflation, investors know that the federal government can at least pay the principal and interest on every dollar that it borrows.
Because Treasuries have no default risk, they have become the equivalent of cash in financial transactions, and on the balance sheets of banks, corporations, pension funds, and individuals. When we talk about a company paying "$10 million in cash" in one deal or another, for example, that generally means not greenbacks but ten million dollars worth of Treasuries. People and institutions (including foreign citizens, corporations, and governments) trade Treasuries as cash-equivalents because the market in which Treasuries are traded is large and well-regulated, allowing all sides to a transaction to deal in a well-understood and safe medium of exchange.
What if Treasuries were no longer available to serve that role? In the late 1990's, when various factors created a series of large federal budget surpluses, there was a genuine concern about the disappearance of Treasuries as a basis for financial transactions. If the entire national debt had been paid down, there would have been no more Treasuries in circulation. This possibility was openly discussed by economists and financial planners at the time, and the need for a deep market in Treasuries was one of the factors that former Fed chair Alan Greenspan invoked when he endorsed the 2001 Bush tax cuts. Without those tax cuts, he reasoned, the global financial system would lose its essential lubricant.
At the time, skeptics suggested that the disappearance of Treasuries might not be a big deal. Arguing what amounts to a dependence/use distinction, they said that the financial markets would find a (nearly?) risk-free alternative, or they might even invent one (perhaps a synthetic security backed by a basket of currencies). Recall that this was the time when financial engineering was viewed as an unalloyed boon to society, making such an argument at least plausible.
We never saw the day when the Treasury market became so shallow that it affected Treasuries' status as the equivalent of cash. (We did, however, get some sense of the problems that might arise. When the Treasury stopped issuing 30-year bonds, those securities became scarce, and that market stopped acting in "normal" ways.) U.S. and global financial planners have continued to use Treasuries as their basic building block.
One of the stated goals of the new majority in the House, of course, is paying down the national debt. While I am deeply skeptical that they would ever do so -- because they would be too tempted to cut taxes every time they cut spending, no matter how deeply they cut spending -- it is at least a matter of professed faith among anti-government politicians and activists that the federal government should not owe any money to anyone.
If one is unhappy about the very existence of federal debt, it would be useful to undermine the national debt's positive uses. If Treasuries lose their status as cash-equivalents, a future Greenspan could not argue that Treasuries are an essential element of a healthy financial system. Therefore, a major advantage (from the anti-government perspective) of the prospect of a U.S. default is that it would make a Treasury bond just another security, no different from securities issued by General Electric, the State of Ohio, or the government of Moldova. The ultimate disappearance of Treasuries would, therefore, not disrupt financial markets. (The disruption would come when the U.S. defaulted on its obligations in 2011, not when Treasuries finally disappeared some years later.)
I have no reason to suspect that this is a conscious conspiracy, or even that anyone drinking tea has even thought about this possibility. Whereas the Bush years seemed to be a sustained and deliberate effort to prove that government could do nothing right and should be distrusted, undermining the financial usefulness of Treasuries would seem to be merely a happy side-effect for Speaker Boehner and his allies. If they continue on their current path, they might soon be able to argue that Treasuries have become too dangerous and volatile, making it important to take them out of circulation by paying down the national debt.
Again, I do not believe that the people threatening to force a default would ever actually pay down the national debt. Still, it is interesting to observe that their current strategy necessarily involves risking the credit-worthiness of the United States -- a risk that, far from being the disaster that most of us expect, might deliver a delightful dividend to those who profess not to be concerned about the consequences of a possible U.S. default.