The Debt Ceiling

This is the topic I have been avoiding studiously as I am not sure there is anything of value I can add.  My basic take is that allowing a government default would be the stupidest thing the US government has ever done and would convince me our democracy is broken.  So there you have it.

Fortunately there are some exceptionally smart people out there giving more sober analyses.  The best have seen is this piece in Project Syndicate by Simon Johnson.  Here is an excerpt:

WASHINGTON, DC – Leading United States congressmen are determined to provoke a showdown with the Obama administration over the federal government’s debt ceiling. Ordinarily, you might expect House Republicans to blink at this stage of the negotiations, but there is a hardline minority that actually appears to think that defaulting on government debt would not be a bad thing.

These representatives – with whom I've interacted at three congressional hearings recently – are convinced that the US federal government is too big relative to the economy, and that drastic measures are needed to bring it under control. Depending on your assessment of “Tea Party” strength on Capitol Hill, at least a partial debt default does not seem as implausible as it did in the past – and recent warnings from ratings agencies reflect this heightened risk.

But the consequences of any default would, ironically, actually increase the size of government relative to the US economy – the very outcome that Republican intransigents claim to be trying to avoid.

The reason is simple: a government default would destroy the credit system as we know it. The fundamental benchmark interest rates in modern financial markets are the so-called “risk-free” rates on government bonds. Removing this pillar of the system – or creating a high degree of risk around US Treasuries – would disrupt many private contracts and all kinds of transactions.

In addition, many people and firms hold their “rainy day money” in the form of US Treasuries. The money-market funds that are perceived to be the safest, for example, are those that hold only US government debt. If the US government defaults, however, all of them will “break the buck,” meaning that they will be unable to maintain the principal value of the money that has been placed with them.

The result would be capital flight – but to where? Many banks would have a similar problem: a collapse in US Treasury prices (the counterpart of higher interest rates, as bond prices and interest rates move in opposite directions) would destroy their balance sheets.

There is no company in the US that would be unaffected by a government default – and no bank or other financial institution that could provide a secure haven for savings. There would be a massive run into cash, on an order not seen since the Great Depression, with long lines of people at ATMs and teller windows withdrawing as much as possible.

Go and read the entire piece, it is sobering reading.