How Innocuous Is a Treasury Default?

Steven Englander, Global Head of G-10 FX strategy for Citi is not very sanguine about a Treasury default, especially as it pertains to foreign holders of Treasurys. From an email today (not online):

We argue below that the impact of a debt ceiling breach may be larger and more permanent on the dollar than on fixed income markets. So it is worth going through the analysis, even though the dollar has so many immediate problems that it seems unnecessarily rude to bring up a problem that may not emerge for another couple of months.

What intensifies the risk is that Congress and investors may be coming to see policymakers as wearing a safety harness as they jump off the debt ceiling cliff. If the financial market reaction is too negative, Congress can have a quick session of mutual recrimination and quickly vote a debt ceiling increase. If policymakers convince themselves that the consequences are reparable they are more likely to take risks. Statistically, there is greater willingness to do bungee jumps than suicide leaps, although very rarely one unexpectedly turns into the other.

We would like to raise the possibility that the impact of a debt ceiling breach could easily fall more on the USD than on fixed income markets. The reason is that unhedged foreign investors in Treasures will not be wearing the safety harness that domestic fixed income investors might be, and may see their losses as having much higher risk of being permanent.

First, consider how the optimists see a breach playing out on short- and medium-term fixed income Treasury securities. Unless an extended breach is expected, many domestic investors will see buying opportunities on any drop in fixed income prices. If the expectation is that a back up of yields would lead to a quick lifting of the debt ceiling, then many investors would see the higher yields as a buying opportunity. Coupons will be paid and any delay quickly made up.

Given how much unused credit there is, one could easily see financial institutions lining up to give loans on the back of Treasury collateral. So businesses and investors that needed the money would be able to borrow on or sell off possibly technically defaulted Treasury collateral.

The perspective of unhedged foreign investors, with currency risk, likely will be much less benign. Many of the arguments in favor of a debt ceiling breach reflect the extremely small probability that Treasury owners will be out significantly in a cash flow sense from such an event.

Foreign investors will see 1) an additional unwanted tool of macro policy added to an already impressive array of non-orthodox policies; 2) another US policy debate that entirely centers on US domestic political convenience and ignores the interests of foreign investors; 3) confirmation that US policymakers favor policy options that will almost inevitably weaken the dollar, even while swearing up and down that they adhere to a strong dollar policy and are simply targeting domestic objectives. (You are about as likely to see a Higgs boson smiling out of your morning coffee as find an instance where the US policymakers of either party made a policy move intended to strengthen the dollar. …

Most importantly, 4) while a domestic bond investor can be made whole in a cash flow sense with virtual certainty, there is no way that unhedged foreign investors can be guaranteed that any FX market reaction will be unwound similarly. Domestic investors may have some reason to see themselves doing as doing a bungee jump, but foreign investors are not sure whether the tension limit is set for 200 feet above the ground or 15 feet below.

House Majority Leader Cantor has a different view:

Cantor said he wasn’t concerned about a negative reaction by the bond market if talks between congressional leaders and President Barack Obama continue closer to the date Treasury says it can no longer borrow money to pay U.S. obligations.

As does Representative Senator Toomey a few days ago:

The “Full Faith and Credit Act” introduced by Toomey in the Senate and Rep. Tom McClintock (R-Calif.) in the House would essentially serve the same purpose as the House Republican “troop funding bill” did in March – it would shift responsibility for a potential default onto the shoulders of Democrats and the White House by calling on the Treasury Department to make only principal and interest payments past the Treasury Department’s Aug. 2 deadline.

In his AEI speech Wednesday, Toomey argued that the measure would “take the specter of default on our debt off the table.”

“It simply instructs the treasury secretary that in the event that we do not raise the debt limit upon reaching it, the service of our debt will be the highest priority,” Toomey said.

He added that “as a former government bond trader and someone who stays in touch with this market, I can promise you the bond market knows the difference between some kind of payment obligations and defaulting on our debt. … Those kinds of postponements are not the same thing as defaulting on our debt.”

And, as noted in the Minnesota Post:

Michele Bachmann, speaking via the Internet to a gathering of Iowa Republicans, said a hard vote against a debt ceiling increase would show that “of all the nations, it’s the United States that’s going to get serious” on fiscal issues.

33 thoughts on “How Innocuous Is a Treasury Default?

  1. Rich Berger

    There’s an easy way out here, Professor. The Dems can just agree to significant budget cuts and tell their constituents that they had to, because “those Republicans are just crazy and we can’t play games with the country’s future!”. Then everyone will realize that the Dems were the sane ones and they will swept back into full control in 2012. Or not.

  2. CoRev

    We are not going to default on our debt! Even if we failed to raise the debt ceiling, our revenue stream would still be in excess of ~$2.6T. To default would take a deliberate decision by our current administration, NOT TO PAY. That’s political suicide.
    What is more likely to happen if the debt ceiling is not raised, is the Executive Branch will “rack and stack” the current obligation streams. Some sill obviously be cut.
    At this point there are several options to continue paying at the reduced level. The least likely is to limit payments to available revenues, ~$2.6T+.
    Another option is to to make the various Trust Funds (TFs) whole, (paid for and self sustaining), and then use the already approved TF borrowing (redeeming intra-governmental treasuries) to make up the difference between the revised spending from the racking/stacking and cutting with available revenue. This is possibly political quick sand, but not suicide if the TFs are truly whole.
    Another approach is to allow some limited (time and amount) debt ceiling rise and also raise taxes to cover a part of the difference between revenue and new spending. This is probably the more rational approach.
    There are some more nuanced approaches if we care to pursue them.
    So, I repeat, only the Dems are using “Treasury Default” for scare mongering, but it will not happen. Not innocuous, not likely.

  3. Peter G. Klein

    Menzie, the points are well taken, but your overall framing — especially the post title — makes this a bit straw-mannish. There’s no question that a default (I prefer the more neutral term “restructuring”) would be bad. But increasing the debt limit, without any prospect of long-term deficit reduction, is also bad. What’s needed, I’m sure you agree, is a balanced comparison, at the margin, of the feasible alternatives, as sort of Coasean comparative institutional analysis.
    This is on my mind because I posted on it last night: My take is somewhat different from yours. Just because restructuring has costs, doesn’t mean it should be taken off the table as some kind of Nuclear Option. Everything has costs!

  4. Jeff

    Menzie, Didn’t you just scold the Republicans a couple posts ago for not pushing a policy of a dollar depreciation?

  5. lark

    One reason to be sanguine about a default is that for the economic health of American workers and the domestic jobs market, down is the correct direction for the dollar.

  6. Russ Abbott

    Why isn’t the following a way around the debt limit?
    The Federal Reserve owns approximately $2.75 trillion in assets. It can sell some of that and give the money to the Treasury. Of course $2.75 trillion won’t last forever, but it will last long enough to give us a chance to elect people who won’t demagogue the debt ceiling.

  7. 2slugbaits

    I guess this is the GOP’s idea of providing the markets with greater “certainty.”
    As Stan Collender pointed out the other day, there is a huge difference between a technical default of a few hours or days when everyone knows that a deal is imminent versus a default with no deal in sight. If 2 August rolls around and everyone believes a deal will be signed on the 3rd, then it’s probably not a big deal. But if the parties are miles apart on 1 August, then we’re in for a rough ride.
    The analysis talks about the effect on the dollar, but a lot of private contracts are tied to the Treasury rate, so if bond prices plunge and yields spike, that will have repercussions throughout the economy far beyond the conventional bond traders.
    As usual, CoRev and Rich Berger give us an inside look at the knownothing view of “real Americans.” And in case CoRev isn’t aware of it, the Treasury is already using Trust Funds to pay for ongoing operations. The debt ceiling was breached already, but it’s the Trust Fund resources that are covering operations right now. So his CSRS retirement check will be the first thing pushed to the back of the line because those Trust Fund bonds supporting CSRS payments are being liquidated right now. No CSRS Trust Fund bond, no CSRS payment And if he had any money in his TSP account, the rules say that access to TSP funds will be frozen (an OPM memo was circulated on this).
    Rich Berger would have us believe that it’s all the Democrats fault because they won’t agree to a rash and crash slashing of the budget without thinking things through. This is stupid. The GOP whined that healthcare didn’t get enough debate despite 15 years of debate, but somehow they expect Democrats to fold on the gutting of SS, Medicare and Medicaid all in a few weeks? This is nuts. This is called cutting governemnt stupid.
    And you gotta love that financial genius Eric Cantor lecturing us on the dollar. This from the guy that lost his shirt financially in 2009 because he was too stupid to understand financial markets and honestly believed Zimbabwe inflation was just days away and got suckered into some crazy “investments.” Clown shows ‘R Us.

  8. Menzie Chinn

    CoRev: Yes, your proposal is similar to Michelle Bachmann’s. I’ll let readers assess for themselves the viability of her proposal.

    Peter G. Klein: Thanks for the link. I didn’t claim the world would end. I quoted who I think is an informed person, who argued that the risk premium would likely rise a substantial amount in response to a default. Argentina has survived multiple defaults; I merely believe it would be better to avoid Argentina’s example.

    Jeff: Yes, I argued for depreciation via monetary policy; but not by pushing up the default risk premia… (which would also tend to push up interest rates, as opposed to expansionary monetary policy). There is an economic difference between the two.

  9. Jeff

    I thought the whole argument in that email was that the risk of default would potentially depreciate the dollar with little effect on interest rates? As an aside, exactly how is monetary policy in the domain of the legislature?

  10. 2slugbaits

    “[Michele Bachmann] said a hard vote against a debt ceiling increase would show that “of all the nations, it’s the United States that’s going to get serious” on fiscal issues.”
    Okay, so let’s get this straight. In Bachmann Land acting crazy makes you appear serious. Right. Got it.
    My wife was in Minnesota over the weekend…hope there’s nothing in the water.
    Minnesota: Land of 10,000 Flakes.

  11. 2slugbaits

    Jeff The Fed is a creature of Congress. In case you weren’t aware of it, the GOP Congress has been making lots of noises about exerting a lot more direct control over the Fed, with a not-so-subtle threat of doing just that if the Fed attempted QE3.

  12. CoRev

    They had the vote on a clean Debt Ceiling bill. Defeated with zero republican votes and Democratic vote nearly split Yes/No and seven voting”present”.

  13. ppcm

    Ironman has an interesting chart smoothing the default probality by countries.
    Few caveats:)
    The larger the country economy, the more liquid the CDs swaps are.
    The domestic currencies depreciations are not included in the events of defaults,when recorded as such in the memorable “this time is different”
    It takes for granted,there is a pure and timely efficient CDs default swaps markets.

  14. colonelmoore

    Is anyone reading the contents of the Cantor and Toomey quotes? It seems to me that the GOP leaders with control over legislation are proposing a legislative backup plan to reassure bond investors that they will continue to be able to redeem their bonds and receive full interest even if Congress stretches this out too long.
    So while the Citi exec’s comments should be taken seriously, they would seem to apply to the situation where such legislation is NOT passed. If Congress instructs Treasury that it must prioritize debt payments, it is the same as a bank saying to a credit card customer that it will not extend his debt limit and he must continue to pay interest while living on cash and carry. On top of that the bank can garnishee some of the cardholder’s wages to pay down a portion of the principal.
    Nothing in that scenario speaks of the cardholder defaulting on the card company. He might default on paying the babysitter and his kids’ allowance though.
    I am not suggesting that we can be sanguine about the government being limited in its ability to pay bills other than debt service. That would be pretty disruptive to a lot of people. But with an annual revenue stream far in excess of debt service, why would Geithner choose to stiff our bondholders before issuing IOUs to federal workers or defense firms?
    The proposed legislation seems designed to stop Geithner from crying wolf by ordering him to do what he should do voluntarily. If he were acting in the interest of the bondholders he could tell them that there is enough revenue to cover their claims and that they will not lose a penny.

  15. kharris

    So in Rich Berger’s view, giving in to political blackmail and agreeing to bad economic policy is the right decision for Democrats. Good to know. Now we have a better understand of Rich Berger’s politics.
    Berger’s argument has long been the GOP argument, couched in a variety of ways. Democrats should simply agree to Republican policies, without reservation. Election outcomes don’t matter. Facts don’t matter. The will of the voters doesn’t matter, but then people who make Berger’s argument aren’t big on the will of the voters in any case. When the GOP is utterly out of power, they argue that Democrats are being partisan and excluding Republicans because Democrats adopt the policies they were elected to adopt. When the GOP has partial power, as is the case now, they adopt extreme partisan positions and avoid legislation that would require help from Democrats to pass, and – as Berger is doing – demand that Democrats simply surrender to Republican bullying.
    Great way to run a country, kids.
    Peter K., “default” is exact and precise in describing missed payments on debt. Restructuring can mean any number of changes in scheduled payments of debt, some of which can even be to the benefit of the creditor. Whatever word you may prefer, “default” is the correct word for what happens if Treasury fails to make a payment on its debt.

  16. Ricardo

    Let’s see, Slug wants to increase the already massive supply of dollars to “stimulate” the economy, wants a weaker the dollar to increase employment, wants to push up the debt ceiling so that legally the government can increase its spending, wants no restraint on future government spending linked to extending the credit limit, and he apparently believes that scarcity is a myth.
    And after all that he wants us to believe that Michelle Bachmann is crazy?!!
    His reasoning reminds me of my father after he had a few small strokes. He had serious problems with his feet and the podiatrist said it was his shoes. His response was, “It couldn’t be my shoes. They haven’t hurt my feet in 20 years so they can’t be huring my feet now.”
    Slug: “Increasing the debt ceiling hasn’t hurt the country since it was first established in 1939 so extending it now couldn’t hurt the country.”

  17. CoRev

    Let’s remember that the Democrats in congress punted on this issue by not voting on a 2011 budget. Playing politics/demagoging with budgets/deficits/medicare is what they have done for some time, now. The adults on the issue have been the Republicans.
    The Clean Debt Ceiling vote is more a measure of how important an issue is the budget deficit to all voters.
    Finally, it is not a default if Congress revises laws associated with specific outlay streams, and the lower payments are in accordance with those revisions. What then, are the budget proposals doing when they revise program payment structures for Social Security and Medicare/Medicaid?
    Defaulting on Treasuries will not happen due to the political ramifications. More importantly if the couple of legislative initiatives are passed restricting the Executive Branch from doing so, defaulting will be illegal.

  18. Rich Berger

    You are entitled to your view, but the converse is that the Democrats are so unwilling to cut spending that they would risk default. As far as bad economic policy goes, the current regime doesn’t have to take a back seat to anyone. That stimulus is still paying dividends here in Recovery Summer 2 – The Wait Continues.
    The default battle is just the latest part of the bigger war about which way the country will go: back to a more limited government or onward to a Euro-style welfare state. You know where I stand – I bet I can guess where you do.

  19. Steven Kopits

    QE3 in the news. Any thoughts on this?
    Looks like the economy continues to unwind, no?

  20. AS

    David Ranson writes in the 5-17-2010 edition of the WSJ that since 1949, federal tax receipts have remained steady each year at about 20% of the GDP, even though tax rates have fluctuated. Why not limit federal spending to about 20% of GDP unless there is a national fiscal “emergency”? Congress and the President could then fight over the definition of what constitutes a fiscal emergency and when to declare a fiscal emergency. A similar prescription to limit federal spending is offered today in the 6-1-2011 WSJ by David Malpass. He suggests limiting federal spending measured as a debt/GDP ratio. If federal spending causes the debt/GDP ratio to exceed a prescribed amount, spending would need to be cut. Then Congress and the President could argue about what the ratio should be.

  21. Rich Berger

    You’re new here, aren’t you? What you say is quite reasonable, in my opinion, but you have to understand that there are fundamental differences in political philosophy behind some of the disagreements on the the debt ceiling. You are proposing that Congress set a budget and live within that budget. On the other side are those that want benefits and rights first, and then figure out how to pay for them later – usually by taxing the rich who have more than their fair share. The joke on the beneficiaries is that there is not enough richguy money to cover the tab. From that fact, two results follow: the non-rich guys get to be taxed more and those benefits are not quite as extensive as promised. Grandma gets the blue pill – she has had a good run, time to go.

  22. Rich Berger

    Too much debt ceiling can be dull, so I recommend watching Congressman Weiner’s performance in recent press conferences. Painful to watch, but amusing and satisfying in the end.

  23. CoRev

    R Berger, I agree with the Weiner press conference especially with the CNN. Can’t look much more guilty. Sorry. we’re OT.

  24. Barkley Rosser

    If Cantor and crew can convince both houses of Congress to prioritize interest payments and paying of due debts, so be it. However, I have said it before and say it again, without that or some other specific instructions about priorities, the Treasury Secretary faces an unavoidable contradiction: a requirement to pay legitimate bills when due and a requirement not to borrow any more. I continue to say in that case, he should ignore the debt ceiling and just borrow more. I bet it will not be more than 150 basis points on US securities to do so, while avoiding being forced to privatize Medicare or default on the US national debt, the consequences of which would be a lot worse than 150 bp.

  25. djt

    The notion that the treasury collects roughly 20% of GDP every year is meaningless, because the actual number varies from 15 to 21%, which amounts to variations of over $800 billion from year to year. The 20% of GDP notion is wrong.

  26. 2slugbaits

    Rich Berger What world are you living in? Do you actually read some of the stuff that you write? Take this kneeslapper:
    On the other side are those that want benefits and rights first, and then figure out how to pay for them later – usually by taxing the rich who have more than their fair share.
    Really? You’re talking about the Ryan plan, right? Because the Ryan plan calls for immediate tax cuts and then promises Medicare cuts in the future. A second round of donuts today, we’ll go on a diet 10 years from now. And since when have the rich seen their taxes go up? Just how is it that the Bush tax cuts raised rates on the rich? And how is it that the Ryan plan raises tax rates on the rich? A more truthful answer to AS would be to admit that the GOP wants to give tax cuts today for rich folks and then throw tomorrow’s grandma over the cliff.
    The joke on the beneficiaries is that there is not enough richguy money to cover the tab.
    Some of us can count and we already know that taxing the rich isn’t enough. But it’s a good start and will get us far. In any event, giving more tax cuts to the rich points the wagon in the wrong direction. And the joke on you is that there isn’t enough non-defense discretionary spending in the budget to cover the tab either.

  27. Ed

    If we pursue a policy of dollar depreciation, can we also pursue a policy of wage inflation? Some of us need a raise and if the dollar keeps falling, then most products we need (food and energy) go up. Yes it may be good for full employment to have the dollar depreciate, but if those who have jobs and those who get those new jobs have a serious loss in standard of living then what good is dollar depreciation? It starts a cycle that only results in a lower standard of living for the 95% of people who work hard for a living and increase it for CEOs, Traders and Politicians which contribute no added value to the economy.

  28. Patrick

    Talk about political Grandstanding. The Big Grandstand of them all is this bogus – “we will have to default” nonsense. We know that it is completely and totally unnecessary, for a simple reason. Debt payments are a tiny fraction of the tax revenues. Put debt payments at the head of the line, and problem solved. Failure to admit this basic reality is either lack of imagination or lack of honesty.
    If it IS dangerous to even think about it, then it is thorough wrong and irresponsible for the Obama administration to raise the spectre of it. All along, this political grandstanding was to get the GOP off their game of demanding spending cuts as part of a bargain on this. Well … thanks to the House vote against the debt ceiling increase without spending cuts – a vote even the Democrats refused to vote ‘aye’ on, the Republicans won on that key point. the deal MUST have spending cuts, and significant and real spending cuts.
    Now, what leverage does the Obama administration have that could get a deal done in 72 hours in Congress? simple! Stop the social security checks. forget stiffing the debt holders, stiff the VOTERS for a change. Phone lines melted as 50 million people demand congress do their jobs, politicians do CYA, debt ceiling bill signed, we move on. 72 hours max and it would be done. All done AT NO RISK TO CREDIT MARKETS. The fact that this default scenario is even a concern and this is not even talked about is an example of lack of leadership from the White House.

  29. Frank in midtown

    The 14th ammendment, particularly during a time of war, renders this moot (in Perry v. US SCOTUS found section 4 made clear that voiding US debt was beyond the power of Congress.) This is political theater(theatre for those who prefer) plain and simple.

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