A U.S. debt default is no longer unthinkable. The reason is not insolvency, but political incompetence. It is time to start thinking about what the default will look like. That is the only way we can prepare for it.
Unlike America, Europe has first-hand experience of debt crises. Europeans are therefore more likely to be resilient in the face of another such crisis. Americans, on the other hand, have almost no clue what kind of an economic earthquake a debt crisis can be. That includes our political leadership, which is of course worrisome. Hopefully, before a crisis hits, they will at least learn how to respond to it by not repeating mistakes made by others in the past. Until they do, though, we all have good reasons to be worried about how they will react to a crisis, once it hits.
It does not help that President Biden and the Congressional Democrats treat the current debt-ceiling negotiations like a game with no consequences. If Congress and the President do not reverse the current policy of spending $1 trillion more every year than they get in tax revenue, the U.S. government will reach a point where it can no longer honor all its debt obligations.
That point is moving closer with every day the current debt problems remain unaddressed. In particular, as I have pointed out here and here, the current negotiations on the so-called debt limit will move us closer to a real crisis. There will not be one now; both sides of the political aisle have everything to win on a stopgap measure, i.e., a temporary increase in the congressional credit line. However, due to the absence of structural remedies to solve the perennial-deficit problem, the risk of a U.S. government debt default will remain largely intact.
An agreement on the debt ceiling will be reached in the nick of time before the current ‘default deadline’ on June 1. It will include modest spending reforms—just enough to make the deal palatable to Republican fiscal conservatives. Those reforms will be inadequate as anti-default measures, meaning the debt clock will continue to tick.
With a stopgap measure that takes us through March of next year (as Republicans seem to prefer), we will be right in the middle of the 2024 presidential election campaign. If American politics continue as usual through next year’s election, we can expect the debt default issue to be treated with traditional, exquisite neglect.
This makes it relevant to return to the question: what would a U.S. debt default look like? This question is almost universally ignored among American media and fiscal pundits in the political discourse. Let us change that and take a look at what actually causes a debt crisis, and how it may unfold.
The Cause of a Debt Crisis
A debt default is a situation where a debtor can no longer fulfill his obligations toward the creditor. The act itself, ‘to default,’ means the same in public finance as it does in private finance: the debtor fails to pay the creditor as contracted. A private citizen who fails to pay his or her mortgage every month defaults on the loan. By the same token, a government that does not make its periodical interest payments to its lenders is in default.
A government default looks a bit different from a private-citizen default. If you lend money to the government by purchasing its treasury or sovereign-debt securities, you get a regular payment of interest as well as your money back when the loan expires. If the government fails to make either form of payment—the recurring interest payment or the principal at the end of the loan—it defaults on the loan.
Government can also make a partial default, something that private citizens are not capable of doing: in 2012, the Greek government declared that it was only going to recognize 75 cents of every euro it owed its creditors. A private citizen could never do the same: we cannot simply call the bank one day and say: “From here on, I only owe you 75% of what it says on the loan document.”
When the U.S. government reaches the point where it defaults, it will likely involve all three forms of default. The most likely scenario is a combination of the first two, which then leads to the third.
The default process begins the day when the U.S. government cannot raise enough money to pay for its ongoing expenses. That day will not come out of the blue but will be the crescendo of rising investor concerns over runaway U.S. debt.
There is no unique ‘trigger point’ for a fiscal crisis, but it is usually the result of a combination of events that involve a weakening—depreciation—of the currency. If it is combined with the deflation of values on stock or sovereign-debt markets, and if this happens at a point where there is general concern over the level of government debt, then the scene is set for a fiscal crisis.
One possible scenario starts with higher American interest rates compared to those of Europe. This depreciates the value of the assets that European investors hold in the United States. Simultaneously, and coincidentally, there is a peace agreement in Ukraine. Such an agreement would motivate some European investors to bring more U.S. investments home; the euro, the Swiss franc, the British pound, and other independent currencies in Europe, are strengthened as a result. Investors who would otherwise have planned to keep their money in U.S. markets are now worried that they will lose more money if they stay in the market.
Another scenario starts with Congress being perceived as uninterested in investor worries. Even if Congress maintains a debt ceiling, investors could lose faith in their ability to pay for their debt. This happens when the debt cost exceeds a psychologically important level without any reaction from Congress. That symbolic level could be $1 trillion:
- It is a staggering number in itself,
- It would make interest on the debt the second largest expense item in the federal budget, and
- It would make interest payments on the debt equal to the annual budget deficit.
In both scenarios, investors begin a systematic move away from U.S. government debt.
Rapid escalation
Foreign investors put their move away from U.S. debt on display by selling Treasury securities they already own, and by staying away from the auctions that the Treasury holds to raise new debt. In the latter market, also known as the primary market for U.S. debt, the flight of investors is manifested in the so-called tender-accept ratio. This is the ratio between the dollars that investors offer at Treasury auctions and the dollars that the Treasury will accept in payments for new debt.
If, e.g., investors tender $100bn at the auction for one-year Treasury bills, and the Treasury is only selling $50bn worth of debt, the T/A ratio is 2.
The sell-off by foreign investors drives interest rates up rapidly, while tanking the U.S. dollar. Normally, rising interest rates mitigate the depreciation of a currency, because investors would find profitable opportunities in the country’s sovereign-debt market. However, during a debt crisis, the very point for investors is to get out of said debt market and refrain from investing any new money in it. Therefore, once the process of debt sell-off is combined with a depreciating dollar, there is no natural economic mechanism that would counter the latter and stop the former.
Domestic investors are now motivated to abandon the dollar. At some point, the T/A ratio falls to 1, and then below that number. At this point, the U.S. Treasury is unable to sell all the debt it needs to sell. In response, they will have to start raising interest rates—and do so rapidly. They hold more frequent auctions and raise interest rates more quickly than usual.
It is unlikely that this will help, for one important reason. Every auction that the Treasury holds is used to roll over debt that just matured. If they borrowed $100bn a year ago under the 52-week Treasury note, they will have to raise at least $100bn this year or rely on fresh, new tax revenue. Since the latter is ruled out by the large budget deficit, the former is the Treasury’s only chance to keep its investors happy. However, since it cannot sell for $100bn, some investors will not get their money back.
Now panic sets in on the sovereign-debt market. The T/A ratio at Treasury auctions begins to plummet. Fewer and fewer investors are interested in buying U.S. debt.
The Treasury is hampered in how high it can raise its interest rates: they are statutorily obligated to promote full employment while also maintaining price stability. Rapidly rising interest rates work like a wet blanket over household spending; as consumers spend less, businesses are forced to cut jobs.
In short, there is a political cap for how high the Treasury can raise interest rates. In the debt default scenario, therefore, there is only one way out: that the Federal Reserve returns to printing money—and to buying Treasury securities with it. This can temporarily stabilize the debt market, but only if the Fed’s securities purchase program is big enough to guarantee a price floor, i.e., interest rate cap, for both the primary market for U.S. debt and for the secondary market (where investors sell debt they already own).
If its intervention is big and bold enough, it may stabilize the situation and prevent the debt crisis from completely crashing the U.S. currency. However, one of the stern conditions for this to happen is that Congress manages to sit on its hands throughout this crisis. Unfortunately, there are reasons to believe that Congress would not stay out of a U.S. debt crisis.
Politics: adding insult to injury
Politicians are known for two things: they never do what they should, and they always do what they shouldn’t.
In the case of a debt crisis, this means they do not prevent it, and then they aggravate it. Their second intervention in the crisis scenario consists of proposals for a Greek-style partial debt default as a way to reduce the government’s debt burden. This idea is not as alien to American politics as one might hope: it can in fact be heard whispered around Capitol Hill.
As the debt crisis unfolds, some members of Congress, primarily but not only from the Democratic party, will quickly propose a partial debt default. They will do so by saying that some investors in U.S. government debt do not deserve to get their money back: their fingers will point to the Chinese government and large U.S. banks, but also at wealthy Americans with investments above a certain threshold.
In a situation where interest rates could easily rise above 20%, such demagoguery rapidly becomes a reality. If Congress moves ahead with a bill to default on part of the federal debt that is held by ‘targeted’ creditors, more investors will decide to sell off the debt they have. This, of course, increases the pressure on the rescue operation by the Federal Reserve and could, if big enough, even disrupt it altogether.
What happens from hereon is anybody’s guess. We could see an escalation with interest rates above 30%; massive money printing could unleash hyperinflation; Congress could shift foot from debt default to extreme austerity measures—with catastrophic, and easily foreseeable results.
We could also see a mitigation of the crisis, if Congress realizes its mistakes, goes into hiding somewhere, and leaves the crisis resolution to the Federal Reserve. It is impossible to assess the probabilities for either of these scenarios or to predict the politics of a full-blown U.S. debt crisis. What we do know, however, is that once the crisis hits, America’s political leadership will be completely unprepared to deal with it.
The only way that Congress can make a difference for the better is to start working on preventative measures today: structural spending reforms that permanently reduce outlays, combined with modest, targeted tax cuts and massive deregulations to stimulate entrepreneurship, investments, and work.
