What Should We Expect if the United States Defaults?

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Though the immediate effects of a U.S. default can be reasonably well predicted, the significant ripple effects cannot.
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  1Center or American Progress | What Should We Expect i the United States Deaults? What Should We Expect if the United States Defaults? By Michael Madowitz October 10, 2013 Te eecs o a U.S. governmen deb deaul will largely depend on how soon heHouse o Represenaives ends is scal brinksmanship. As he 2011 deb-ceiling sand-o showed, he eecs o a poenial deaul will no wai unil he reasury deadline o Ocober 17, and he 2008 nancial crisis proved i is exremely dicul o predic wha will break in he nancial sysem unil i has broken. 1  Wih ha in mind, his issue brie examines wo basic scenarios o a U.S. deaul: one in which he deb ceiling resuls in a deaul or only a shor ime—say, less han one busi-ness day—and one in which he Unied Saes is unable o borrow or a longer period.In eiher case, a ailure o li he deb ceiling in a imely manner will resul in:ãSignicanly increased ineres coss on he naional debãLong-erm negaive impacs or he U.S. economy ãReal, angible, and cosly consequences or everyday AmericansãSevere, unpredicable consequences or he U.S. and he world nancial sysemãMacroeconomic consequences ha increase wih each day he deb ceilingresrains aciviy ã An immense amoun o unpredicable downside risk o he U.S. economy I is dicul o oversae he amoun o risk involved in ailing o raise he deb ceil-ing—no because i is challenging o esimae he cos o each individual consequence, bu because i is so dicul o conceive all o he relevan consequences. Due o he vasuncerainy abou possible oucomes, his issue brie likely undersaes he naure o herisks involved.  2Center or American Progress | What Should We Expect i the United States Deaults?  The known risks to the economy Tere is no ambiguiy abou wheher ailing o raise he deb ceiling will harm he U.S.economy. Wha is ambiguous is how much harm will be done. Te 2011 deb-ceilingsando oers some insigh. A ha ime, Federal Reserve Chairman Ben Bernanke es-ied beore Congress abou he consequences o ailing o raise he deb ceiling, saying,“I would be exremely dangerous and likely [a] recovery-ending even.” 2  Te simples cos o he economy o pin down is how much long-erm ineres-rae increases will cos axpayers direcly. Like all bonds, U.S. reasury-issued deb,or reasuries, have ineres raes ha refec a risk premium. Te risk premium onreasuries is currenly very close o zero, which means he ineres coss o our naionaldeb are quie low, despie he ac ha publicly held deb is jus under $12 rillion. 3   Alhough mocked or he lack o marke response a he ime, he Sandard and Poor’sdowngrade o he U.S. credi raing in Augus 2011 appears prescien now. S&P saedha “he downgrade refecs our view ha he eeciveness, sabiliy, and predicabiliy o American policymaking and poliical insiuions have weakened.” 4 An increase inhe ineres premium paid on he ederal deb currenly held by he public would cosaxpayers a lo—an increase beween 0.1 percenage poins and 0.5 percenage poins would cos axpayers beween $120 billion and $600 billion over he nex 10 years. 5  As a recen reasury repor noed, here are some direc parallels o he 2011 deb-ceiling sando ha serve as a baseline o comparison or some o he coss o simply approaching he precipice. 6 I we assume ha he curren sando is resolved in a similarmanner as he las one—specically, a he las minue, bu beore any deauls occur—he U.S. economy would sill incur a hos o negaive consequences. Te reasury repornoes ha he S&P 500 Index declined roughly 17 percen in he period surroundinghe 2011 episode, and in he same nancial quarer, household wealh ell by $2.4 ril-lion and reiremen asses ell by $800 billion; i ook six monhs o reurn o pre-crisislevels aer no quie hiting he deb ceiling. 7 Unsurprisingly, he eecs on consumerand business condence were also srongly negaive and ook monhs o reurn o heirpre-crisis levels.I he curren deadline is no me, similar, presumably larger eecs can be expeced.However, a number o complicaions make pinning down an exac cos dicul. 8 While wealhier Americans will primarily be aeced by changes in asse prices, all Americans will be aeced by he ripple eecs in credi markes. Virually every kind o credi used by middle-class Americans—rom credi cards o suden, auo, and home loans—isconneced o ineres raes on reasuries. ypically, he issuers o hese credi producsmake heir pros by charging an addiional ineres spread on op o reasury raes, soan increase in he ineres rae on reasuries alone will drive up borrowing coss.  3Center or American Progress | What Should We Expect i the United States Deaults? During he las episode, he spread on home loans signicanly increased aer he sand-o, wih 30-year xed raes jumping by almos 0.75 percen—abou $100 per monh—or a ypical morgage on a median-priced home. 9 No only would a similar even slow he pace o renances and purchases, bu i he risk premium on U.S. bonds increases, Americans wih adjusable-rae morgages would also see he paymens rise on heirexising morgages.Increased credi coss would have a signican direc eec on he recovery, even inhe case o a very shor-erm deaul. As invesors demand a larger risk premium onreasuries, his cos will be passed hrough o nancing coss in he housing and auosecors. Aer sruggling over he pas ew years, hese secors have recenly regainedseam and have begun o lead he recovery. Due in par o avorable lending condiionsand pen-up demand, auo sales are on pace or heir bes year since 2007. 10 Te housing marke—which oen leads economic recoveries—has been exremely slow o respond o his downurn, in large par because i led he downurn. Forunaely,he marke has markedly improved over he las year, bu he housing recovery is very ragile. I here is a delay in liing he deb ceiling, he bes-case scenario or he housingmarke is no prety. Te addiional risk premium generaed by a deaul on reasury  bonds would be passed ono consumers in he orm o higher ineres raes, and heexperience rom he las sando suggess xed raes would increase by an even largeramoun. Higher raes slow he pace o homebuying and, coupled wih recen increasesin ineres raes, would have a chilling eec on he renances ha have been one o hemajor channels o moneary simulus hroughou he recovery. 11  None o hese coss are rivial, especially a his ragile momen in he economic recov-ery. Deaul will carry long-lived increases in he risk premium paid on reasury bonds, which ler hrough o every ype o borrowing and banking done by Main Sree America. Increased volailiy in asse prices and decreases in consumer and businesscondence as well as household wealh are harmul o an economy a any poin; givenhe curren sae o he recovery, even hese consequences—which are he leas severeand mos easily undersood ones o a emporary deaul—will impose real, signicancoss on average Americans. ‘Good’ news  While a deaul should resul in subsanial shor- and medium-erm declines in U.S.asse values and long-erm increases in ineres cos o he naional deb, i is unlikely heUnied Saes would experience permanen capial figh on he scale ha oher naionshave suered. Many close subsiues or reasuries are oher U.S.-based asses, such ashigh-grade corporae deb and consumer deb.  4Center or American Progress | What Should We Expect i the United States Deaults? Bonds rom oher counries will become more avorable o invesors, bu uncerainy around growh prospecs in Japan, he Unied Kingdom, and he greaer euro areasuggess ha invesors will no fock o any paricular asse. In many ways, he euro isgiving he Unied Saes a buer righ now. I invesors could sill buy deuschemark-denominaed German bonds, i is likely ha even he poliical brinksmanship in heUnied Saes would have driven invesors ou o U.S. reasuries and ino Germangovernmen deb. In some ways, he Unied Saes is experiencing a dividend rominsabiliy in he euro zone. Other potential risks to the economy I he American economy were a ypical one, a deaul would go somehing like his:Invesors would ge spooked, pull capial ou o U.S. socks and bonds, ake losses, andmove heir money o saer asses in oher counries. Back in he Unied Saes, ineresraes would rise and asse prices and he U.S. dollar would all. Impors would becomemore expensive and infaion would rise. Gross domesic produc, or GDP, and employ-men would all. A deaul would be caasrophic, bu in an uterly predicable way. Overime, he all in he value o he dollar would make U.S. manuacuring and expors morecompeiive, leading he economy ou o a deep recession and bringing he counry back o reasonable condiions aer a mere los decade or wo.Te U.S. economy, however, is anyhing bu ypical. In he scenario described above, bondholders are ypical invesors who hold bonds hey perceive o be o relaively highrisk and reurn, so hey are judicious in he ransacions hey srucure based on hese bonds. A deaul causes invesors o ake a hi and sell a a loss, and he deauling coun-ry is le paying higher ineres raes wih less oreign invesmen. Te response is oendeemed a “figh o qualiy,” and invesors end up buying up radiionally sae asses—ypically, reasuries.Since he infaion-adjused reurn o holding reasuries is close o zero, U.S. deb unc-ions less like an invesmen han a source o liquidiy. By ar, he larges concern wihhe House’s brinksmanship is ha he U.S. economy, specically reasury deb, is helynchpin o he domesic and inernaional nancial sysem exacly because he U.S.governmen has a 200-year hisory o never behaving his irresponsibly.Tis sysem’s eec on every American should no be undersaed. Large corporaionsoen make payroll and oher ransacions by using aciliies ha require nondeauledreasury-issued deb as heir oundaion. Many Americans have asses in money-markeunds, eiher direcly or hrough pensions, many o which rely on he saey and liquidiy o reasuries. Every second he Unied Saes is in deaul inroduces unwelcome uncer-ainy ino a very liquid nancial sysem ha relies on a high degree o rus and cerainy.
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