How Will Markets React if the United States Government Defaults?

July 25, 2011

Nobody really knows the answer to the above question with certainty.  It’s a mystery.

Governments that defaulted in the past have been punished but not with equal severity, and a U.S. default would contain many unique elements.  The United States is the world’s biggest economy.  The dollar dominates reserve asset portfolios and has no serious challenger for that role.  This would be a default contrived by politicians, not the act of an insolvent government out of other options for meeting its fiduciary obligations.  The United States has much better demographics than other advanced economies and excels in comparisons of real economic growth and labor productivity.  It has a history of surviving more serious crises and harder challenges than the current one.  Natural resources are plentiful, its people inventive.  A default might be viewed as a temporary stoppage, analogous to a strike of public workers, that will pass and prove cathartic for going forward in a fiscally sustainable manner

A United States default could happen for two reasons. The first would be because one or both sides believe that predicted negative consequences are grossly overstated.  Such a belief would be based on the various circumstances not found in other defaults, some of which are listed above.  The second reason would be the calculation that market penalties would be outweighed by gaining one’s way politically.  Republicans and Democrats have very different visions of America in the future.  A compromised middle ground would leave many outspoken and politically energized people feeling betrayed.  In a land with slogans like “Live free or die” and “Give me liberty or give me death,” winning the political struggle isn’t just a strongly favored outcome.  It’s the only acceptable result, the only path that would allow life, liberty and the pursuit of happiness to continue. 

Both justifications carry a gamble.  A U.S. default would take the country into unchartered waters.  The repercussions might actually be worse and longer lasting than the doomsayers like Bernanke have postulated and worse than experienced by other countries in the past.  America’s special status also means that it can fall further from grace.  It wouldn’t be the first time that political leaders had miscalculated.  The First World War happened because many governments played their game theory metrics incorrectly.  Lehman Brothers was allowed to fail to show that not every institution is too big to fail and to prevent creeping moral hazard.  The Vietnam War was waged because of an overstated domino theory.  Early in the period of floating exchange rates, British officials gave a slight downward nudge to sterling to get the currency below $2.00 where pent-up pressures had been building.  This tactic in March 1976 backfired, precipitating a runaway slide of the pound that forced the government to seek IMF aid later that year.

I happen to agree that long-term U.S. interest rates will rise less if there is a default than feared, and that the dollar will avoid a free-fall.  On interest rates, I take comfort from Japan’s experience where extremely low interest rates coexists with debt of around 200% of GDP.  On the dollar, I see simply no near-term rival to replace its role in the international monetary system.  The only possibility could have been the euro, and that currency has its own debt baggage.

That said, it would be foolish to run this experiment just to find out once and for all how markets would react to a default.  The possibility of truly awful adverse ramifications is not insignificant and cannot therefore be disregarded.  The United States possesses WMDs that could settle its conflicts in the Middle East and elsewhere much more quickly and cleanly than the means with which it chooses to compete, and it does this for a very good reason.  Quick, decisive victory isn’t worth the risk.  Elected leaders must say no to Swiftonian modest proposals and, thankfully, usually do when they understand what’s at stake.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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