Government

Weirdly, A Default Could Make Investors More Eager To Lend The U.S. Money

With the debt ceiling threshold 10 days away, the big question on everyone's mind is: what will happen if the government defaults? The story usually goes like this:

1. Congress does not raise the debt ceiling in time.

2. The U.S. defaults on its debt.

3. Financial markets immediately freak out because U.S. debt is no longer "risk free."

4. As a result, investors will start demanding higher interest rates to lend money to the U.S. government

But some investors see it differently, according to survey conducted by J.P. Morgan and posted by Sober Look. While most agree that U.S. default will send short term interest rates into a tizzy, there is a substantial split over what will happen with long term debt — and a majority of investors think interest rates on long-term debt will actually fall, not rise, if the U.S. defaults on its debt.

10 year yield under default
J.P. Morgan

Investors still see U.S. Treasury bonds as among the safest investments in the world. And if a U.S. default leads to chaos in the financial world, investors will seek safety in ... Treasury bonds.

In the long run, though, this would not be a good thing. As Adam Davidson recently wrote in his column:

While this possibility might not sound so bad, it's really far more damaging than the apocalyptic one I imagined. Rather than resulting in a sudden crisis, failure to raise the debt ceiling would lead to a slow bleed. Scott Mather, head of the global portfolio at Pimco, the world's largest private bond fund, explained that while governments and institutions might go on a U.S.-bond buying frenzy in the wake of a debt-ceiling panic, they would eventually recognize that the U.S. government was not going through an odd, temporary bit of insanity. They would eventually conclude that it had become permanently less reliable. Mather imagines institutional investors and governments turning to a basket of currencies, putting their savings in a mix of U.S., European, Canadian, Australian and Japanese bonds. Over the course of decades, the U.S. would lose its unique role in the global economy.

The U.S. benefits enormously from its status as global reserve currency and safe haven. Our interest and mortgage rates are lower; companies are able to borrow money to finance their new products more cheaply. As a result, there is much more economic activity and more wealth in America than there would be otherwise. If that status erodes, the U.S. economy's peaks will be lower and recessions deeper; future generations will have fewer job opportunities and suffer more when the economy falters. And, Mather points out, no other country would benefit from America's diminished status. When you make the base risk-free asset more risky, the entire global economy becomes riskier and costlier.


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