THECAPITALMARKETSINITIATIVE
May2011
TO:
InterestedParties
FROM:
LaurenOppenheimer,SeniorPolicyAdvisorandJimKessler,VPforPolicy
RE:
TheDominoesofDefault
"Thecornerstone
of
theglobalfinancialsystemisthattheUnitedStateswillmakegoodonitsdebtpayments,"says
MarkZandi,ChiefEconomistatMoody'sAnalytics.
"If
we
don't,we'vejustknockedoutthecornerstoneandthesystemwillcollapseintoturmoil.
"1
Mainstreameconomistssaythatfailuretoraisethedebtceiling-inessence,todefault-wouldhaveadevastatingandcascadingeffectontheu.s.economy.Butwhilethere'sanintensedebateinWashingtonaboutwhenandhowtoraisethedebtceiling,there'sbeenfarlessfocuson
exactly
whatwouldhappenintl.S.capitalmarketsandhowitwouldaffectMainStreetiftheu.s.defaulted.Thismemoattemptstoexplainthefivemostsignificantandlikelyeconomicconsequences-ordominoeffects-Americawouldfaceifwedefaultonourdebt.
WhatisDefault?
WhentheU.S.runsabudgetdeficit-takinginlessrevenuethanitspendseachyear-itmustborrowmoneyinordertokeepthegovernmentrunning.Howdoesitbridgethatshortfallbetweentaxesandspending?
It
issuesTreasurybonds,whichareboughtbyinvestors,whoareinessenceloaningmoneysoUncleSamcankeeppayingSocialSecuritychecks,fightinginAfghanistanorkeepingthenationalparksopen.Treasuryoffersbonds,sometimesreferredtoasTreasuries,T-billsornotes,whichrangefrom3-monthsto
lOsyears
inmaturation.WhilesomeinvestorsengageinactivebuyingandsellingofTreasuriesforshort-termgains,investorstypicallypurchaseTreasurybondsforonereason-theyarewidelyconsideredthesafestinvestmentintheworld.Thebondspayinteresttoinvestors,butgenerallyatalowratesincetheallureofthisinvestmentissafety.Becauseoftheirsoundness,manyinstitutionalinvestorsrelyonT-bills.Pensionfundsandinsurancecompaniesusetheinteresttopayretirees.Publicplans,includingSocialSecurity,aresomeofthelargestholdersofTreasuries.AndindividualretireesalsoownTreasuriesdirectly,usingtheinteresttopaytheirbills.Defaultwouldoccurifthedebtceilingwerebreached.
If
theu.s.doesnotraisethedebtceilingandallextraordinarymeasurestakenbytheTreasuryDepartmentareexhausted,theU.s.couldhavesevereproblemsinpayingbackitsdebts.ShouldtheU.s.failtomakeaninterestpaymenttoanybondholder-evenforaday-theresultwouldbedefault.
The
U.S,
governmentwouldlosetheabilitytoborrowfromcreditorsbeyondourexistingoutstandingcurrentdebt.Inessence,ournationalcreditcardwouldbecut-off.Thenwewouldfaceanimmediateandstarkchoice:attempttousetheremainingrevenuecominginfromtaxesandfeestomakegoodonthegovernment'sobligationstopaytheinterest,orrefusetomakethoseinterestpaymentstoinvestors-thusdefaultingonourdebts-andusetheresultingsavingstokeepthegovernmentrunning.IfCongressdecidestohonorourdebtsandkeepmakinginterestpaymentsonT-bills,thegapbetweenrevenueandspendingwouldbeabout$125billioneachmonth,basedonCongressionalBudgetOffice(CBO)estimatesofourcurrentyeardeficit,"Thealternative-toforgopayingbondholdersandthusdefaultingontheinterestpaymentsonthoseTreasurybills-wouldrelieveonlysome,butnotnearlythemajority,ofthemonthlyshortfall.
WhichisWorse:AGovernmentShutdownorDefault?
Defaultingonthedebtisvastlydifferentthanagovernmentshutdown.Whatmakesdefaultsodifferentandmuchmoredangerousisthatithasnotonlyshort-termeffects,butsignificantmediumandlong-termonesaswell:
Short-term:
Ifthe
u.s.
defaultsandthereisn'tenoughcashtocoverallfederalexpenses,basicgovernmentpaymentslikeSocialSecurityandveterans'benefitscouldbesuspended.Thatwouldcausegreatinconveniences,butthesesuspendedpaymentswouldeventuallybemadeupandpeoplewouldbemadewholewithretroactivepayments.
Medium-term:
Evenafterthosepaymentsresumed-whichtheyeventuallywouldwhenthedebtceilingisraisedandthegovernmentcanborrowagain-theeffectwouldbeenduring.Imagineatypicalmiddle-classfamily:defaultisabitlikethatfamilymissingaseriesofpaymentsontheirhome,car,insurance,andcreditcards.Thiswouldchangetheirfortunesforalongtimebydrivingdowntheircreditratingfromgoodtopoor;sure,they'dbeabletoborrowagain,butitwouldbemoreexpensivesimplybyhavingthatlowerrating.
Long-term:
Thistypeofdefaultismostakintoalargecompanythatsuddenlycannotmeetitspayrollorpayitsvendors.Questionsariseoverwhetherthecompanywilleverbethesame.Employeesmaywellseeksomewhereelsetoworkastheynowhavedoubtsaboutthecertaintyandtimelinessoftheirpaycheck.Customersmayseektobuygoodselsewhere,becausetheyarenotsurethecompanywillbeabletoserviceitsproductsormakegoodonthewarrantyonitsgoods.Vendorsmaydemanddifferenttermsforpurchasesoftheirproductsandservices.Investorsmayflee,loweringthevalueofthecompany.
DominoEffects:FiveConsequencesofDefault
Sowhatexactlyarethemostlikelymediumandlong-termeffectsofdefault?Whatwouldcausethesedominoestofall,andhowmighttheyaffecttheaverageAmerican?Thefollowingarebriefsketchesofthefivemostseriousconsequencesofdefault.
Third
Way
Memo
2
1)Treasurybondratesrise.
Asnotedabove,the
u.s.
governmentdoesnotcollectenoughintaxestooperate,soitmusttakeondebtandsellbonds.Typicalbuyersofbondsareinstitutionalinvestors(likepensionfunds),foreigncountries(oftensovereignwealthfunds)andindividuals(usuallythroughmutualfundsand401Ks).InvestorsbelievethatthereisvirtuallynochancethattheUnitedStatesgovernmentwouldeverdefaultontheseloans.Asaresult,Treasurybondspayaverylowrateofreturn.Lowriskmeanslowinterestrates.Ifthegovernmentdefaults,creditratingagencieswoulddowngradetheratingofTreasurybonds.Adowngrademeansthe
u.s.
wouldhavetoraisetheinterestrateitoffersforthesebondsinordertogetinvestorstocontinuebuyingthem.Thisisbecausetheirnumberonedraw-arisk-freeinvestment-wouldnowbeafallacy.Asananalogy,imagineifamajorsafetydefectwerefoundinallVolvos-acompanythatsellssafetyasitsmainfeature.Thecompanywouldhavetoresorttoofferingexpensiveenticementstogetcustomersbackintotheshowroom.TheT-billistheVolvoofinvestments.Itisallsafetyand(withapologiestoVolvo)littlepizzazz.DefaultwouldthusmeanthecostofborrowingfortheU.S.governmentwouldincrease,perhapsdramatically.•BothPimcoandJ.P.MorganestimateariseinTreasuriesof50basispoints(0.5%).3•J.P.Morganestimatesthattheincreasedcostofgovernmentborrowing(theinterestwepayonourpubliclyhelddebt)wouldbumpupannualdeficitsby$10billionintheshortrunandby$75billionperyearover
time."
•J.P.MorganestimatesthathigherTreasuryrateswouldcauseourGDPtodecreaseby1
%.5
•Forevery1%changeinGDPgrowth,thereisanestimated0.46%changeintotalemployment,accordingtoeconomistWilliamSeyfried."Usinghisestimation,the
u.s.
wouldshed640,000jobs.'Tobeclear,thisisaconservativeestimateasdefaultisa"blackswan"eventthathasnoAmericanprecedent.Anotherpossiblescenario:"Marketparticipantswouldtakethedollar,Treasuries,andtheS&P500outbehindthebarnandshootthem,"saidSteveEast,chiefeconomistforHeightAnalytics,""Theultimatedamagecouldbefargreater,"agreesTerryBoltonofJ.P.Morqan."TheUnitedStateshastheluxuryofborrowingmoneymorecheaplythananyothercountrybecauseTreasurybillsarethesafestinvestmentonearth.Butthatwouldnolongerbethecasewithdefault.Losingthissafetyfeaturewouldbeadevastatingblow,jeopardizingourabilitytoborrowatlowrates,ahugeadvantageforAmericaandpartofourengineforeconomicgrowth.Whilenoonelikesdebt,ifitcostsonecompany5%interestforaloanandasecondcompany6.5%,whichislikelytobemoreprofitable?Thatlowerrateissomethingwecan'taffordtojeopardize.
Third
Way
Memo
3
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