By Kristin Carew, Carnegie Mellon University
Imagine that the United States has just breached the debt ceiling with no compromise in place, throwing the federal government into a state of fiscal turmoil.
The government immediately begins efforts to delay or reduce the impact of its inability to borrow by shifting money around and pulling funds from non-essential programs. However, investors understand that there is little hope for preventing default without a compromise on the debt limit, as the Treasury needs to roll over its debt in order to make interest payments. Experts following U.S. political developments see that an agreement on the debt ceiling is not forthcoming. This conclusion trickles down to investors, who realize that default is inevitable.
There is a massive global selloff of Treasury bonds, and their prices plunge. The price crash in the Treasury securities market, once seen as a safe haven, paralyzes the repo market. The repo market, which allows firms to swap low-risk investments like Treasury debt for cash, begins demanding more collateral and jeopardizes the financial health of firms relying upon repo transactions to bolster their balance sheets. Firms that once used their Treasury holdings to finance investments and projects are forced to use actual cash to do business. The destabilized economy is not conducive to raising money in the equity markets. After firms exhaust their available credit, obtaining extra cash requires selling assets. The selloff that ensues includes stocks, other types of bonds, and even physical assets like buildings and factories. As firms liquidate their non-Treasury holdings to build cash reserves, prices decline across many asset classes.
Treasury selloffs have a devastating effect on money-market funds, which sell low-return, low-risk shares to investors. Because of their focus on minimizing risk, these funds are large holders of Treasury securities. When Treasury debt is defaulted upon, or when its prices crash, these funds are forced to “break the buck” on the dollar shares they sell. This means that shares of the fund previously valued at one dollar are re-priced at below one dollar. If a single major fund is forced to lower share value, a run on all money-market funds can occur as investors scramble to get out before their shares are revised further downward. This leaves many funds at risk of collapsing, which would wipe out millions of risk-averse investors. Missed payments on Treasury debt and crumbling money markets deprive millions of investors of the secure returns they counted on.
Banks, even those based outside the United States, have tremendous exposure to Treasury debt. Many were left in poor financial health after the 2008 crisis, and these firms are quickly bankrupted by the new crisis. While many institutions were rescued with capital infusions during the last financial crisis, the fiscal crisis at the government level now prevents bailouts. Other institutions were saved during the 2008 crisis after selling themselves to healthier firms, but stable banks will be rare, if they exist at all. This massive chain of bankruptcies among financial institutions reverberates throughout the economy, unchecked by government intervention. Credit dries up to an unprecedented extent. Consumers are unable to obtain loans, and they might also be unable to withdraw cash from their accounts; the FDIC runs out of funds necessary to make good on its insurance obligations as the entire financial system collapses. Businesses, many of which rely on short-term credit to cover payroll, are unable to pay their employees. Lack of credit forces businesses to conducts layoffs, and those without large cash reserves are bankrupted and forced to shut down. In cases where credit is available, borrowing costs have increased dramatically, because the benchmark Treasury rate has been driven up by the U.S. default.
The dollar, which is not backed by gold or any other reserves, relies upon the widespread belief that the “full faith and credit” of the United States is sufficient support for a currency. Default permanently damages the credibility of the United States and dramatically devalues the dollar. Dollar inflation devastates the foreign exchange reserves of many other governments and institutions. The U.S. dollar is a reserve currency held by many governments in their foreign exchange reserves and used as the currency for global markets like oil and gold, and the effects of its collapse are far reaching. The effects of a U.S. default may eventually result in the loss of reserve currency status.
There is more than one way for the U.S. to default as its fiscal health deteriorates. The first is intuitive: it misses payments on Treasury securities. The second is less obvious. Because the number of dollars in circulation is not constrained by reserves levels, the U.S. can create and circulate as many dollars as it needs to cover payments. This approach is likely to trigger hyperinflation, or extreme levels of inflation created by unchecked growth of the money supply. A famous example of this occurred after World War I in the Weimar Republic, when Germany simply printed more paper marks to cover war reparations. Some U.S. debts are Treasury Inflation-Protected Securities (TIPS), which pay investors more money to account for however much inflation occurs over the life of the bond. However, most Treasury bonds pay a fixed coupon in nominal dollars, the value of which diminishes as inflation grows. This allows the government to meet its obligations by increasing the money supply, but doing so still destroys the credibility of the U.S. Treasury, and the impact on investors whose coupon payments become worthless is similar to the impact of missing payments altogether.
A default by the United States, whether via currency devaluation or missed payments, is unlikely to be limited to Treasury debt. As Treasury Secretary Timothy Geithner predicted several months earlier, payments on other U.S. obligations are also discontinued. U.S. military pay and benefits are suspended, along with spending on defense and national security. The federal government stops making the payments needed to provide Social Security, Medicare, and Medicaid benefits, leaving retired, disabled, and lower-income individuals penniless and unable to obtain medical help. Unemployment surges as businesses fail, but the U.S. can no longer fund the unemployment benefits paid out by states. Salaries and benefits for federal workers are suspended, and these employees cease to perform the tasks necessary to keep the government functioning. Government facilities are forced to close down. Schools are deprived of federal funding. Without a remedy for the government’s fiscal shortfalls, the country’s social safety net and public services begin to disappear even as the need for them rapidly increases. A lack of federal financial support will eventually cause these problems to trickle down to the state and local levels of government.
The net result of these effects is a financial crisis dwarfing that which occurred in 2008, and an economic depression many times the magnitude of the last several years’ recession (and perhaps also more severe than the Great Depression). No sector of the economy is left untouched. Even after the U.S. negotiates a higher debt ceiling, catches up with debt payments, restarts government functions and services that were deprived of funding, reins in the inflation it caused, and sorts out the fiscal issues like deficit spending that formed the root of the crisis, everything does not go back to normal. Borrowing costs for the United States will be persistently elevated, and Treasury securities are unlikely to regain their status as risk-free investments. This means that, as the U.S. begins to roll over debt again, it will be more expensive than before the default. Businesses that were bankrupted in the crisis will not be resurrected, nor will the banks that failed as a result of their Treasury exposure. The U.S. will be left with a devastated financial system and extremely high levels of unemployment. The dollar will almost certainly have lost its status as a reserve currency, along with much of its value. After the shocks that occurred over all asset classes, the U.S. will be a far less appealing place for foreign investors to send their capital. The U.S. GDP will shrink; a mere slowdown of growth would be an optimistic scenario.
Clearly, these are not desirable outcomes. We can only hope that decision-makers with power over the federal government’s borrowing and spending have considered them.
Sources: MarketWatch, the New York Times, the Examiner, Slate
