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Selling a Default that Nobody’s Buying

Can the U.S. really default — or is the threat just theater of the absurd?

Let’s be clear: There is no such thing as a default for the U.S. Government. Should the government fail to raise the debt ceiling, credit rating agencies will lose, lawyers will win and the financial markets will go about their business.

The value of U.S. Treasuries (namely bills, notes, bonds and other securities issued by the government) will remain unchanged.

Treasuries, like the dollar itself, are backed by the full faith and credit of the U.S. Government. The government may hit its self-imposed spending limit on Aug. 2, but faith in the U.S. as a AAA-rated entity will not be impacted. Most simply, because the people with the money (the market) are not interested in disrupting the system.

U.S. Treasuries are different than other assets. They are more than a credit. They are a contract. To be considered in default, one side or the other has to press the claim.That’s not happening here. Nobody wants to stop using them. There is nothing to gain by rocking the boat. The threat of default is a paper tiger created by the rating agencies.

Treasuries are embedded into the current world economic system as a AAA-rated credit and a safe haven for global liquidity. Neither one of these factors is changing.
Trillions of dollars of U.S. Treasuries are used in financial markets everyday as collateral for the complex web of transactions that make up the fundamental underpinnings of the world economic system. They are the baseline against which all other assets are priced and against which financial contracts are written.

Individual insurance policies and credit cards use them as a reference point, as do complex municipal investment plans and corporate depreciation schedules. Treasuries, unseen, are everywhere in the system.

Unwinding Treasuries as a AAA-rated credit would take an army of lawyers and an immense amount of time. It’s going to be far easier to simply redefine a AAA rating as a U.S. Treasury, rather than rewrite and restructure all the contracts that currently use them as collateral (provided all parties in the contracts agree).

And there’s every indication that they do. Interest rates on Treasuries, which fluctuate inversely to their price, have stayed low — or dropped — as the discussions in Washington continue.

Further enhancing the strength of the U.S. Treasury is the demand by foreign governments and wealthy foreign nationals to secure their wealth — by moving it offshore and into the protection of the U.S. Government.

This motivates a large percentage of foreign purchases of Treasuries and demand for U.S. dollars as a reserve currency. More than $12 trillion is held in reserve currency around the world — just shy of the size of the entire U.S. economy.

This is particularly true for developing nations like China or Mexico, where political turmoil could undo decades of economic gain. (Compare that to the political turmoil of two parties fighting in the U.S. — both of which rely on hundreds of millions of dollars in fundraising for their existence.)

If nobody’s buying, who is selling the default scare?

Attorneys and lobbyists: The U.S. Treasury needs about $125 billion in credit each month to meet all the government’s obligations. This represents about 40 percent of all spending. In theory, if further borrowing were cut off, the government would automatically have to reduce its spending by 40 percent.

This is a daunting prospect, particularly since there’s no precedence for who would get paid first. Soldiers or retirees? States or foreign bondholders? It would start a legislative slugfest that would make the rush for TARP money look like a well-organized line at Disney World. (Creating a big opportunity for attorneys and lobbyists to put in their two cents in.)

The second: Bond-rating agencies. These folks need to prove their relevance after falling asleep at the wheel precipitating the 2008 meltdown. The ratings agencies have a history of being lagging indicators and seem to be making a special effort this year to appear proactive.

The problem they’re facing is nobody seems to be listening to their warnings. Failure to raise the debt ceiling poses a particular problem for them. If the rating agencies define the U.S. as technically being in “default” Aug. 3, but nothing changes, it’s the bond-rating agencies’ value which will take a potentially lethal hit.

Mark Phillips is an economist and former Wall Street analyst. He holds an M.S. in applied economics from the University of Michigan and a B.S. in economics and philosophy from the London School of Economics.



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