MAKING SENSE -- October 5, 2013 at 11:25 AM ET
Four secrets of debt default: Two to scare you; two to reassure
The good news is that the bond market isn't acting like default is imminent. The bad news is that if the Treasury runs out of money, they can't simply prioritize who gets the remaining checks. Photo courtesy of Flickr user Tyler Merbler.
I was reminded that the government shutdown can be catastrophic for some when one of my daughters, now on furlough, told me how painful it had been to tell some of the lesser-paid office workers she manages to go home, without pay.
"How are they going to survive if this lasts beyond a paycheck or two?" she wondered.
But considerably more menacing, on a macroeconomic scale, is the threat of an unraisable debt ceiling and the specter of the once-unthinkable: default on U.S. bonds.
There are six more-or-less-discussed ways of avoiding such an outcome:
The Republicans relent.
President Obama relents.
Even if Republicans remain intransigent, the President orders the Treasury to continue to borrow, as economist Henry Aaron urged him to in The New York Times last week, claiming that his higher Constitutional duty is to honor America's economic obligations. He cited the 14th Amendment, Section 4: "The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned."
The President and Treasury find some way to channel current revenues to keep paying interest on the national debt, as well as redeeming maturing bonds as they come due, thus forcing deeper cuts in other government expenditures.
The U.S. starts to sell its gold stocks, currently valued at something like $345 billion. The Treasury owns 261.48 million Troy ounces. (A Troy ounce is worth $1318 at the moment.)
The U.S. Treasury mints a trillion-dollar platinum coin or uses some other trick and the Federal Reserve buys it, thus creating the money needed to tide us over.
So what is likely to happen? Well, who is most likely to know? And that brings us to:
Reassuring Secret 1: The bond market, the most liquid market in the world, in which all the world's major investors participate. The bond market is reacting as if there's no crisis in sight.
Let's take a step back to explain. The great fear of a debt default is that it will make borrowing money extremely difficult, which is to say, unaffordably expensive. That's because a default will supposedly terrify the world's investors, inducing them to charge a usurious rate of interest to lend us any more money. We would become like Greece, Lehman or AIG.
But if we're on the road to ruinous interest rates on our bonds, how is it that the rate has dropped substantially in the past month, and hasn't even risen in the past week? The 10-year note was at 2.64 percent at end of Friday. With inflation running at a historically rock-bottom 1.5 percent and it having to be worth something to borrow money -- money's so-called "time value" has been 2 percent or more for many years -- investors would seem to be getting no compensation at all for the risk of a U.S. default. In fact, investors seem to like U.S. debt so much, they are arguably accepting a negative interest rate.
Reassuring Secret 2: Insurance against a U.S. debt default has risen but is still strikingly cheap by global standards -- strikingly cheap for a country supposedly on the cusp of default, that is, and it actually went down Friday.
Called a "credit default swap," or CDS, this is an insurance contract that would pay off (if the U.S. were to default costs) 36 cents per $100 worth of insurance at the close of Friday's market, down about 20 percent from where it stood earlier that day. (Contracts on U.S. debt are actually priced in euros since, as Annayln Kurtz of CNN Money succinctly puts it, "if the United States defaults, who wants to be paid back in dollars?")
Admittedly, there is not a lot of money tied up in U.S. CDS right now and only institutional investors do the buying and selling. But these are people (okay, speculators) putting their money where their mouths are, just the opposite of political pundits, whose mouths are the source of their money.
Yes, the price is up from .22-.24 from the months leading up to Sept. 23. But the price rose as high as .65 in the summer of 2011. And insurance against the default of U.S. debt is still cheaper than against the default of Dutch debt (.47), Belgian (.57), Japanese (.63), French (.66), Korean (.72) -- not to mention Chinese (1.38), Spanish (2.09), Italian (2.35) or Greek (8.09).
In terms of odds, the U.S. price of .36 means paying a $36-per-year premium to buy $10,000 worth of insurance, which works out to the odds of default, anytime in the next year, of about 250-1.
Okay, so much for the good secrets. Let's end with two scary ones.
Scare Secret 1: As RBC Capital Markets via Cardiff Garcia writes, the system just either runs or it doesn't: "The Treasury's systems do not clearly mark what scheduled payments are for what reasons, so it is impractical to try to prioritize payments."
Or, as the most recent chief of staff at Treasury, Mark Patterson, and the Washington Post's Ezra Klein discussed:
Klein: What about the technical difficulties here. Treasury isn't writing hundreds of millions of checks by hand. It's all automated. In the event of a breach, how flexible are those systems? How likely is it that we could choose what to pay without a lot of errors?
Patterson: That's an underappreciated complication with any prioritization scheme. The U.S. government's payment system is sprawling. It involves multiple agencies. It involves multiple interacting computer systems. And all of them are designed for only one thing: To pay all bills on time. The technological challenge of trying to adapt that to some other system would be very daunting and I suspect that if we were forced into a mode like that the results would be riddled with all kinds of errors.
Scary Secret 2: Markets can be disastrously wrong. Think of the stock market booms of the late 1920s, the mid 1960s and the late 1990s. Think of the housing market just six years ago. Or the oil market at the very same time. Herd behavior. The herd might complacently buy one of the several reasons commonly given by those who think the Rubicon will never be breached: Bonus: One winner from the shutdown: Netflix?
And here's this week's answer to a question from a reader:
Ronald J. -- Lake Wales, Fla.: Who is correct: what causes (most or all) recessions? Why cannot government "fix" or "make corrections" to them? Is Paul Krugman, speaking for John Maynard Keynes' theories, "more correct" or are "conservatives," speaking for Austrian economist Friedrich Hayek, "more correct"?
Paul Solman: Hey, this is the PBS NewsHour, Ronald: devoutly (some have said "pathologically") even-handed. We present the arguments; you make the call. So watch our story from 2009 on Keynes v. Hayek, maybe read my follow-up post (which I just re-read and rather like) and, if you're in the mood for an econ film festival, watch the Keynes v. Hayek video raps "Fear the Boom and Bust" and "Fight of the Century", though both were produced by Hayekians.
Now despite my PBS-mandated impartiality, and just between us, Ronald, I will go so far as to say that both Keynes and Hayek had deep insights into the mechanism we call "the economy." See my Making Sen$e Business Desk post mentioned above for elaboration.
Who was "more correct," you ask? It depends on the situation: crisis or prosperity? And it also depends on which Keynes or Hayek you're asking about. Keynes changed his mind often, while Hayek began life as a socialist.
In general, Keynes was a proponent of government intervention to fix "market failures," which were threatening the fabric and credibility of capitalism when he developed his most famous theories. But he passionately believed in markets nonetheless, as opposed to the comprehensive economic planning of socialism or fascism.
Hayek, by contrast, was skeptical of the presumptions of government intervention. But he too acknowledged market failures and the need of societies to do something to address them.