Representative Paul Ryan (R-WI) recently said in an interview with CNBC that our creditors would accept the US defaulting on its debt "for a day or two or three or four". Ryan is widely considered to be the intellectual leader of the GOP, so much so that Newt Gingrich was recently prompted to apologize to Ryan when he said he wasn't for Ryan's Medicare reforms.
Our creditors most certainly will not accept a default. If this happens, or if we get close to it happening, we are heading off a cliff. Our bonds will, overnight, become worth peanuts compared with what they are now. The US will plunge into recession or worse, and the situation will not recover in my lifetime.
How long has this been known? The first bonds issued by a government for the purposes of funding itself were those of Venice in the 13th century. Venice sold the bonds, telling the bearers that they would be paid an annual interest payment on the face value, and that they could be held indefinitely. The bonds were a huge success. And Venice made their payments on the debt consistently. As Kenneth Silber writes "From 1262 to 1379, Venice never missed an interest payment, solidifying the credibility of the new instruments." They were as good as cash for transactions, and a very good place to invest money.
But Venice defaulted on its obligations. Now, there are two senses here in which default can have meaning. One is that a debt is "repudiated." This is what the North made the South do upon cessation of the Civil War. Anybody who owned Southern bonds was out of luck, they had no value. But this isn't what Venice did. They merely defaulted by stopping their interest payments for a few years in the early 1380s, and then resumed. This is akin to what Ryan is talking about.
What happened? The bond market in Venice never recovered. What people had for more than 100 years considered to be as good as cash was suddenly something with risk. The risk abruptly went from nothing to substantial, and people reasonably began to worry that they had much less money than they thought they had.
Does this sound familiar? It should. The crisis in 2007, resulting in the worst recession since the Great Depression, was caused by the same thing. Credit markets locked up because suddenly people realized they had less money than they thought they had. Things that were supposed to be as good as cash (insured securities backed by mortgages) were, overnight, perceived to be inherently risky; investors thought they might end up holding worthless paper. So they tried to cash everything out immediately, and refused to invest in anything. This has caused the liquidity trap that we're currently in. Everyone just wants cash and wants to stick it under a mattress.
And, to be honest, mortgage backed securities were esoteric. They weren't held by that many people. Treasury notes, on the other hand, are owned by everybody. So if you thought 2007 was bad, you just wait until August 2011. It will be armageddon.
So what do politicians, in particular the GOP, say about this? "Don't worry", they say, "we can still make payments on the debt and just default on other things. And hey, the markets didn't crash when there was a possible government shutdown." They also contend that just because the markets will react negatively, it won't be so bad. As Senator Pat Toomey said recently, “a disruptive series of events are not a catastrophe.”
This is horrifyingly ignorant. It is true that the bond market has not yet responded to the possibility of risk. But if there appears to be any possibility of a default for even one day, something that has zero risk will suddenly have some risk. And the market knows that if we head towards default one year, it's just as likely to happen the next year, and the next after that. Treasury bonds will no longer be a perfectly sound investment. They may be mostly sound, but they will be priced at a significantly higher rate, and many investors will try to cash out immediately. As Roger Altman, former deputy secretary of the Treasury said, “if America were to default, even for 24 hours, that would have an unprecedented and catastrophic impact” on global financial markets.
So, if you have to worry about one thing (other than global warming), worry about this. If this happens, it's the end of the US as we know it.