How the 2013 US default will play out

Here’s what will happen with the US debt ceiling over the next few weeks.

Neither side will compromise to raise the debt ceiling. President Obama, who is in the right, won’t negotiate because caving in to blackmail will undermine his and every future president’s authority. Hardline Republicans won’t negotiate because they’re reckless and want to bring about a default and a fiscal collapse in order to implement libertarian utopia.

Wall Street, defence, and regular business leaders will call their republican senators and tell them in no uncertain terms that future campaign contributions will go to Democrats unless they back off. Most Republicans will be burned by this, but the Tea Party wont back down because they have grass roots and rich libertarian supporters.

The treasury will run out of money on October 15 or thereabouts, and then will hold back all payments equally until they can be covered by tax receipts. That will include Treasury bond payments, and the US will be in default. Rating agencies will downgrade US debt to hot potato status. The market will maintain the belief that the US will eventually pay the arrears after an unknown delay.

The Fed, being the only well-funded and well-run branch of government, will intervene massively. Mr Bernanke will generate trillions of reserves (Fed credit to US banks) and use it to buy Treasury bonds from the banks. This will keep Wall Street banks solvent and mitigate the fall of Treasury prices. They’ll fall by a few percent instead of crashing. The Fed may also elect to buy stocks to calm stock markets and later gain revenue. This intervention will be held tightly by banks and not generate consumer price inflation.

A fall in the value of US treasuries means a rise in the interest rate that the US has to pay for all its accumulated debt, not just new debt (although the new rate gets phased in over around five years as bonds mature). Something like a 2% rise is burdensome. At some level, be that 4% or 5% or similar the market starts to believe that the US will never pay some of the debt and interest rates spiral to 25% or more because of the risk. That makes it certain that the debt won’t be paid in full, and US debt changes form a safe asset to a speculator’s trade. That’s what happened to Greece. It’s not clear if the Fed will be able to avert the latter scenario.

Either way, if the debt limit isn’t raised and the US defaults the US will have to pay higher interest. It may be much higher or impossibly higher. If you’re concerned about lowering the US debt burden, default is not what you want!

Central banks outside the US, particularly in Japan, may elect to cover their own financial institutions’ exposure to Treasuries by generating reserves in Yen, Pounds, etc. This will keep the financial system from collapsing and convert immediate paper losses to long-term recession, as happened 2008. The ECB, because it’s in the grip of Teutonic myths about money and debt, will be the last to react and will do so in half-measures, putting several European financial institutions in peril and adding to the ongoing Eurozone crisis.

The collapse of demand for Treasuries doesn’t pose survival challenges to real economy firms. Successful US firms have large cash reserves. The abrupt fiscal tightening will significantly hurt firms in certain sectors. However the secondary effects are severe and they’ll come back to affect all US businesses through the world economy.

The largest foreign holders of US Treasuries, China and Japan, have these bonds because for years they maintained a trade surplus with the US. Every year Americans (the private sector) import more things from China than they sell to China, so that excess dollars pile up at the Chinese central bank. Then along comes Uncle Sam, takes back the dollars and spends them in the US economy, and gives China yellow debt certificates called Treasury bonds. The Chinese effectively subsidise American consumption (they work for less) in order to boost their own production, and Americans maintain unaffordable consumption by going into paper debt. To a lesser extent the same happens vis-a-vis Japan, Korea, Taiwan, and Germany. Outside of a crisis scenario, no-one expects the US to pay back accumulated debt. To creditors it’s a long-term safe investment that pays interest.

When the US defaults, this arrangement breaks down. Suddenly the Chinese will no longer accept Treasury bonds and will demand dollars to replace the amount they hold as they mature. The Fed may decide to fly plane loads of newly printed Benjamins ($100 bills) to China and take back expiring Treasuries to shred them. China won’t accumulate the dollars but will try to spend them immediately on asset purchases, in the US and abroad. This will have three major effects:

  • The value of the dollar will fall sharply compared to other currencies, as there will be a flood of dollars chasing assets worldwide. American wealth will be reduced significantly, and there will be inflation through imports.
  • Imports to the US, including things like industrial components and iPads, will be much more expensive for Americans or unaffordable to US firms. Demand, production, profits, and stocks will fall sharply around the world.
  • America’s creditors will pick up devalued stocks worldwide, making a long term shift of capital from American to Asian and a few European holders. Iconic US firms such as Apple may come under hostile takeover by foreign capital.

The US may instead refuse to pay cash for Treasuries that mature and no-one can force them because the US has aircraft carriers. However the economic effect will be the same or worse: If the US bluntly refuses to honour Treasuries the dollar will fall further and trade will halt as foreigners will trust neither Treasuries nor dollars.

Eventually, perhaps after a few weeks, the US will find a procedural way to end the debt ceiling stalemate. They’ll remove or convince recalcitrant congressmen to vote for a permanent increase. However, the damage done to the economy will be permanent. Markets will resume their upward trajectory but will not recover their lost value. Capital will have been permanently transferred from the US to its creditors. Global demand, income, and profits will be permanently lower than they were before the crisis. The US will not regain credibility with bond investors until they make a constitutional change to put debt under control of the executive.

In the medium term the default will hurt China, Germany, and other Asian countries harder than the US. They will lose a profligate customer who’s buying on credit and will have to substitute US demand with demand of their own. That may happen, if money flows liberally enough in the Asian middle and upper income classes, but most likely demand and the overall economies will be permanently depressed. In the long run world economies will move past their dependency on US demand and move on.

The US will be left a much more insular and backward economy than it is today. With the dollar sharply devalued and no foreign credit the US will have to produce and consume domestically, which it can do. Expect American cars, American PCs and smartphones actually made in the US, a resurgence of blue-collar workers, higher nominal incomes and much higher consumer prices. People will buy durable goods and not gadgets. Sort of how it was in the 60s. In a way this will be more balanced and robust and may appeal to conservative nostalgia. However, it’s not the path to a libertarian powerhouse. If anything, with capital severely weakened and a greater need for domestic labour, a stronger social contract or New Deal will be needed to see America through the aftermath.

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