Wednesday, July 20, 2011

This Isn't Hyperbole

. Wednesday, July 20, 2011

In a post below, Dr. Oatley makes the case that a US debt default won't be earth-shattering. It's a good post, and notes that previous debt ceiling line-toeing -- including one instance of accidental default -- hasn't had catastrophic effects. I agree completely with his point that as a bargaining strategy it makes sense for the House GOP to take an extreme position. I've made similar points before. But I think Oatley is discounting the downside of a US default quite heavily. There are a number of reasons for this.

First, the US has to rollover $500bn of debt in August alone. Suppose that interest rates go up by 60 basis points, as a study Oatley cites argues occurred following the 1979 technical default. That would cost the US $3bn in borrowing costs next month. But there is no reason to think that this would be the only cost. The 1979 default was an accident caused by a technological mistake. A default today would be an intentional choice made by a recalcitrant legislature. The reason why everyone expects a much bigger market response is because this time really is different. Oatley doesn't think so:

In other words, markets might distinguish between a sovereign default caused by massive over-borrowing and collapsing export revenues (where the likelihood of being made whole is zero) and a technical default by the United States (where the likelihood of not being made whole is zero).

Perhaps, but in this case the likelihood of not being made whole is not zero. It's much higher than that. And while interest rates haven't jumped in anticipation of default risk, that doesn't mean the effects would be slight. If the "catastrophe" view is correct, there may not be a way to price in that sort of risk. Or perhaps markets are convinced that a deal will eventually get done, despite the brinksmanship. In any case, I'm not quite as ready as Oatley to accept that just because interest rates haven't spiked financial markets don't think a default would be a big deal. That's not what financiers are telling legislators. They're scared and getting angry.

As I wrote before, the financial system could be devastated by a debt downgrade. The financial system depends on having a lot of liquid, high-quality collateral. If Treasuries can't serve that function it wreak havoc on balance sheets and cause another panic. I'm actually less concerned about the effect of default/downgrade on government borrowing costs as on the financial system, and a newly-disrupted financial system is not what the economy needs right now. Nothing in Oatley's post reassures me on that front.


This Isn't Hyperbole




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