Saturday, July 16, 2011

Why defaulting isn't an option

I was in a hotel room tonight, so I found myself channel surfing, and Bill Maher was on. His guests were trying to understand the urgency of the debt ceiling crisis (a crisis that exists only because our politicians choose to make it a crisis). Several times they got confused, with one guest arguing that it didn't matter if we defaulted for a short period, because it would just trigger increased interest rates, which the Fed could just turn around and modify.

His confusion surrounds the imprecise use of the term, "interest rates." There are a lot of interest rates that the government interacts with. One of them is the prime lending rate, which is the rate at which banks loan money (it's actually a starting point which can be modified by circumstances, term, etc.) The prime lending rate is based on the rate that banks will charge each other for a loan, called the federal funds rate. This rate is currently 0-0.25%, which means that banks are essentially loaning each other money without or with very low interest, allowing prime lending rates of approximately 3.25%.

That's the number that Bill Maher's guests were talking about, but it has nothing to do with the debt ceiling crisis (at least directly). To understand why, we need to look at a second type of loan: treasury bills are IOU notes that the government writes over short periods of time. An investor buys one of these T-bills for some amount less than they are worth and in 3 to 12 months depending on the T-bill, they "mature", meaning that the government pays off the investment at its face value. So, if you bought a $1000, 3 month T-bill for $990, you would make a $10 (1%) profit in 3 months when the government paid it off.

The rate is based on a number of factors including supply (the amount the government wants to borrow) demand (the amount investors want to invest) and the risk that the note won't be paid off. In the case of the U.S. government, that risk is considered to be as near to zero as it is possible to get in the realm of investment. Because U.S. government debt is considered the standard for low-risk investment, much of the market is geared toward treating the T-bill rates as a baseline.

A change to that baseline (e.g. because of a single default) would radically change the investment landscape in a way that we can't fully know, because it's never happened before. This is because investors (not the Fed) would not be willing to buy T-bills at the same rate. So, what's wrong with a higher interest rate on our debt? Well, for starters, it means that all of our current projections for the federal deficit over the next several years would rocket up. What's more, all of the large, institutional investors (including nations) who buy U.S. debt would have to scramble to determine if it even made sense any longer, or if they should be buying someone else's debt, possibly reducing demand, and further driving up interest rates. The impact of this on the value of the dollar, inflation and other aspects of our economy is a matter for debate, but it would likely produce a shock wave through every aspect of the economy.

Ultimately, the U.S. would continue to find buyers for its debt, but not before the market had to absorb a fundamental shift in its underlying assumptions at a time when we're just coming out of a major recession. Such economic turmoil at a time like this would be very likely to trigger a return to recession or worse. It could also destabilize investment firms, causing another wave of failures. During the last wave of failures, we relied on the U.S. government's excellent credit rating to borrow funds to see us through the crisis. That, of course, would be changed this time around.

So, as you can see, the "interest rate" on T-bills is very different from the Fed-controlled federal funds rate, and the lack of concern showed on Maher's program is just the result of a misunderstanding about how much impact this process could have. I'm no economist, and I'll admit to ignorance on some of the details, here, but what's important to understand is that ignorance is the basic problem, here. We just don't know how bad this would be because it's unprecedented. We just know that it's a pretty awful idea, and there's no excuse for not paying our bills.

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