Stepping into the debt-default unknown

·3 min read

No one wants to test the strength of the debt ceiling. The current Treasury Secretary, backed up by many of her predecessors, says that it's so rock-solid that running into it will be catastrophic.

Why it matters: The brinkmanship we're currently seeing over the debt ceiling is the kind of dance that no sane person would perform on the edge of a real cliff. One possible explanation is that the cliff isn't quite as vertiginous as politicians are being warned it is.

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What they're saying: The official stance on hitting the debt ceiling, from Treasury Secretary Janet Yellen, is positively apocalyptic:

Doing so would likely precipitate a historic financial crisis that would compound the damage of the continuing public health emergency. Default could trigger a spike in interest rates, a steep drop in stock prices and other financial turmoil. Our current economic recovery would reverse into recession, with billions of dollars of growth and millions of jobs lost.

Between the lines: The U.S. hasn't defaulted on its debt since Richard Nixon took the dollar off the gold standard in 1971.

  • No one can be certain about the consequences of a default — and in fact there's no indication that the markets are concerned about such an event, with stocks near record highs and interest rates near record lows.

Where it stands: The two-year debt ceiling suspension enacted in 2019 ended on August 1, 2021. Since then, Treasury has been spending down its reserves. Absent another hike or suspension of the debt ceiling, then at some unknown point in the next few weeks it will be forced to default on all or some of its obligations.

Be smart: Most debt defaults are damaging because they cause financial harm to creditors. It's far from clear that a U.S. sovereign default would have that effect.

  • In times of uncertainty, investors often turn to safe assets, and specifically to Treasury bonds. Moreover, when there's any problem with liquidity in the Treasury market, as there was in March 2020, the Fed has proved that it's willing and able to use its unlimited firepower to step in and buy as many Treasury bonds as the market wants to sell.

  • A U.S. default, in contrast to most other defaults, would cause no losses: The recovery value would be 100 cents on the dollar. In that sense it would be akin to the technical defaults by Fannie Mae and Freddie Mac when the two agencies were placed into conservatorship in 2008. No creditors suffered losses when that happened.

Reality check: Hitting the debt ceiling would almost certainly cause harm to individuals who rely on timely checks from the government, from members of the armed services to people living on Social Security to anybody receiving the monthly child tax credit.

The bottom line: Congress often waits to see market panic before acting. In a weird way, the worst outcome for the United States might be that the country defaults and the market barely wobbles. That could push the brinkmanship — and individual hardship — to even more ludicrous extremes.

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