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Allowing the U.S. Treasury to default on its obligations because of a failure to increase the sovereign debt subject to limit would be a colossal blunder. Fortunately, that’s not what those advocating tough conditions in exchange for a debt limit increase are saying. The issue presented by many in the news media is whether Congress would elect to willingly torpedo the U.S. Treasury market – and, by extension, the global financial markets that rely on Treasuries as risk-free collateral – by refusing to increase the debt ceiling. Paul Krugman has advanced another popular narrative, namely that the “constant lectures about the need to reduce the budget deficit…represent distorted priorities, since our immediate concern should be job creation.”
Achieving growth is certainly vital to securing the future, but policymakers need to stay focused on the real default issue: whether the terms of the debt limit increase this summer will be sufficiently tough to ensure that the nation’s debt-to-GDP ratio is stabilized and eventually sharply reduced. Ironically, the greater risk of default comes from an increase in the debt limit that fails to enact tough budget rules and substantial reductions in federal outlays.
Analysis of the price dynamics of the dollar, U.S. stocks, and Treasury notes during the previous debt limit “scare” in 1995-1996 makes clear that market participants discount noise about a technical default arising from a budget impasse. The last debt crisis occurred from October 1995 to March 1996. Just as today, there was significant noise about a potential technical default with some extreme budget hawks discussing the issue with a non chalance that could supposedly “spook the markets.”
The crisis began with letters from the Treasury Secretary in July of 1995 (see chronology on page 26 of this document). The Treasury Secretary warned of disaster if the debt limit was not increased in October 1995. By the first week of November, it was not clear whether Treasury could maintain sufficient cash balances to meet obligations without eclipsing the new debt ceiling. On November 15, Treasury announced a 12-month debt issuance suspension period which allowed Treasury to redeem bonds held in government accounts (the Civil Service fund) and raise cash from public markets to pay $25 billion in interest.
What was the market’s response as Treasury came to the edge of a technical default cliff due to an impasse in the budget negotiations? Perfect calm (see chart above – and note, the values for the different asset classes across the y-axis are all scaled to 100 for comparison purposes).
The yield on the 10 year Treasury note fell by 2.4% from October 2 to November 15, the S&P 500 rose by 2.1% (annualized increase of 19.5%), and the dollar gained against other major currencies. The market shrugged off what was an imminent technical default absent unprecedented maneuvers initiated by Treasury.
Nine more weeks of extraordinary steps by Treasury were required to avoid default until Congress – on February 8, 1996 – authorized Treasury to issue about $29 billion of securities to ensure that the March Social Security payments could be made. By explicitly excluding certain categories of debt-financed spending from the debt limit, Congress effectively ended the risk of default. How did the market react during this harrowing episode of unprecedented cash management exercises to avert default? Well, the 10 year Treasury yield declined by another 5.7%, the S&P shot up by 10.5% (annualized gains of 75%), and the dollar strengthened against trading partners and other major currencies.
The media narrative during this time was that cash balances were dwindling, legal options were few, and default seemed inevitable. The price action during this time showed no evidence that any market participant trading on this thesis was very badly burned. Indeed, prices in every asset category moved in precisely the opposite direction as would be hypothesized by those arguing intense fiscal policy negotiations “spook the markets.”
On March 12, 1996, Congress extended the types of security issuance that would not count against the ceiling – and the debt ceiling was formally raised on March 29, 1996. It was only in the denouement to the crisis (from the special exemption on February 8 to the formal debt limit increase on March 29) that yields on the 10 year note rose (by 68 basis points to 6.34%), the S&P shed some of its gains, and the dollar weakened. How is it that prices fell during the period of the crisis when the risk of default had been taken off of the table? Movements in bond, stock, and currency markets appeared to have nothing to do with concerns about technical default. By demanding tough concessions and moving to restore fiscal discipline, budget hawks during this period were able to implement policies that created strong economic fundamentals. The balanced budget and sharp falls in debt ratios that resulted from these tense negotiations made the U.S. Treasury more creditworthy, not less, which reduced the risk of default.
The same dynamics are at work today. Many traders would be quite happy if concerns about a debt limit stalemate caused Treasury yields to increase because it would create a profitable trading opportunity once the inevitable debt ceiling increase is signed into law. At less than 3.3%, current U.S. 10 year borrowing rates show no evidence of concern about the debt limit vote. More significantly, these low yields provide no incentive for anyone in government to actually advocate default. Countries just don’t willingly destroy their domestic currency and sovereign debt market when they are able to access international capital markets on such favorable terms. Those mistaking tough talk from negotiators for true intent would do well to remember this fact – the aforementioned historical account. Indeed, those demanding the toughest concessions today actually have a strong pro-creditor bias. (At least one plan would allow creditors to continue to receive principal and interest payments even as other spending is cut off.)
Rather than strictly worrying about technical default in 2011, policymakers and analysts should focus on debt levels and deficits in 2012, 2013, and 2014. That’s when the rest of the developed world will likely have stabilized debt ratios and substantially reduced deficits, even as the U.S. is projected to continue its path towards insolvency. At 6.3% interest rates (the average of the 1990s) and current spending projections, the U.S. Treasury would have to collect 6.4% of GDP in taxes simply to make debt payments in 2021. This would be more than one-third of all revenue expected to be collected in that year, even after (or if) tax rates are increased to pre-2001 levels. If not adjusted sharply in the next few years, this path may not be alterable without significant (and unnecessary) short-term pain. This is the real default crisis and it can only be averted with a tougher stand on a debt limit increase in 2011.