Dangers of Default

As you know, the USA is in danger of default if we don’t either raise the debt ceiling or provide some combination of spending cuts and tax increases. I still think we’ll see a deal that entails all three of these and prevents a default, despite the political quagmire in Washington DC.

The left contends that a default would be catastrophic while the right is saying it wouldn’t be that big of a deal. The liberals’ logic is basically that life as we know it will change forever in America if we default. The conservatives’ logic is basically that countries default all the time and they still survive. Who’s correct? As usual, the truth lies somewhere in between what the conservatives and liberals say, but the question of who is more correct depends upon what timeframe we’re talking about.

In the short term (five years or less), a default would be the disaster the liberals contend it would be. America would be in a financial house of pain and it would cause an epic shockwave to reverberate through the global markets. The dreaded double-dip recession (or the continuation of the present recession if you don’t believe we exited the recent recession) would be all but certain. I suspect stock, real estate, and commodity prices would take a pounding. Interest rates would likely surge, as well.

However, in the long term (a decade or more), a default now could continue being catastrophic. Yes, it’s possible it would not only be no big deal, but it may even be a good thing because it’ll finally force us to get our fiscal house in order, as the conservatives say. I still disagree with their thinking, though. They contend that countries default all the time and they end up stronger after they default than they were before, while providing several examples. That’s true in many cases, but I don’t recall a case involving the default of the country with by far the world’s largest and most powerful economy, which happens to be the USA. It’s not a risk I’d be comfortable taking, personally.

I think we want to avoid default. Suppose we do. Does that mean we’re out of the woods? I don’t think so. We still have the ratings agencies to worry about. For a little context, the USA currently carries the best rating in the world with all three major ratings agencies, namely Moody’s, Fitch, and S&P. However, recently Moody’s and S&P recently put the USA on negative credit watch, meaning that there’s a possibility that the USA could catch a downgrade.

So is a downgrade coming? I view the risk of a downgrade as a low-probability event, though I also view the risk as more likely now than at any other time in America’s history and the risk is large enough that it’s something we have to consider.

Moody’s has made it clear that they won’t downgrade the US unless we actually miss an interest payment on our bonds (AKA default on our bonds, which has never happened, FYI). Presumably, if we raise the debt ceiling and do some blend of tax hikes and spending cuts, we’d be safe from Moody’s. That’s what their statements imply to me.

I believe that if we’re going to get a downgrade, it’ll most likely come from S&P, who, though coming to the party a bit later than Moody’s, is also being much firmer. I read the S&P negative watch report, and they left the window open for a downgrade if the US raises the debt ceiling without any tax increases or meaningful spending cuts. Basically, S&P is worried that since this potential raise of the debt ceiling has proven to be a very big fight, they aren’t comfortable banking on the US being able to raise its debt ceiling again in a year or two or whatever. Interestingly enough, S&P does their debt/GDP calculation a bit differently than I do and theirs show the USA in much better shape than mine do, but until I understand why theirs are different and I agree with their methodology, I’m sticking with mine.

So, suppose S&P does a downgrade. What would happen? In addition to the aforementioned economic calamity, we would obviously see interest rates rise, making borrowing more expensive for the government, as well as people and businesses since many interest rates are tied directly to Treasury rates.

But, wait, there’s more. What’s even worse than having a lot of interest rates tied to Treasuries is also having a lot of other securities whose ratings are tied to Treasuries. In other words, if Treasures get downgraded, all these securities get downgraded, too. We’re talking about the possibility of an immediate downgrade in all debt from Fannie Mae and Freddie Mac, mortgage-backed bonds, municipal bonds, and agency bonds. If these securities get downgraded (which is not guaranteed, but is possible and indeed likely), the holders of the securities, such as banks and insurance companies, see increased capital requirements, meaning they need to keep more money on their balance sheets to guard against the risk of default. Moody’s mentioned this in their release, saying that if the Treasury notes get downgraded, they’d take a lot of other stuff down with them (note that some of these securities, like agency-backed MBS, are not officially rated, per se, but carry an implied rating of sorts).

Personally, I want to avoid a default and I don’t buy the right-wing argument that default would be no big deal and would be good in the end. If we can get our fiscal house in order without default, then we should because that is far better than defaulting.

I’ve said it before, and I’ll say it again. The period for political partisan posturing has passed (how’s that for alliteration?). Do the deal and be done with it. I think we can get our fiscal house in order without the pain of default, but our leaders have to get serious about it.