With Cantor and Kyl exiting the debt ceiling debates with their best drama queen flourish this week, it was inevitable that the debt ceiling would be of discussion on the Sunday shows. But in true disinformation fashion that really embodies the
June 26, 2011

With Cantor and Kyl exiting the debt ceiling debates with their best drama queen flourish this week, it was inevitable that the debt ceiling would be of discussion on the Sunday shows. But in true disinformation fashion that really embodies the state of journalism these days, the conversation falls far short in really pointing out what the problems are.

For a low info voter (or someone not forced by John Amato to watch these shows week after week), it sounds as if this is just a politics-as-usual posturing by both parties...a kabuki theater where everyone understands the ending. But let's be clear: this theater, these dramatics are wholly the fault of the Republican Party, because they have stated that their number one goal--more important than taking care of their citizens, their fat money donors, hell, the country as a whole--is to make Obama a one-term president. They raised the debt ceiling nineteen times in eight years during the Bush administration without once feeling the need to create this drama. As Chrystia Freeland points out, the GOP's choice to play these games right up to the deadline is causing uncertainty in the market as well.

So why not call a spade a spade and point out exactly the consequences of the GOP's gamesmanship?

Any delay in making an interest or principal payment by Treasury even for a very short period of time would put the U.S. Treasury and overall financial markets in uncharted territory, and could trigger another catastrophic financial crisis. It is impossible to know the full impact of such a crisis on overall economic growth and on Treasury’s financing costs. However, the lessons from the recent crisis suggest that several damaging consequences will likely result, ultimately raising Treasury’s long-term funding costs and increasing the burden on the American taxpayer. These consequences stem from five developments that could likely occur if Treasury were to default on its obligations as a result of a failure to raise the debt limit in a timely manner.

First, foreign investors, who hold nearly half of outstanding Treasury debt, could reduce their purchases of Treasuries on a permanent basis, and potentially even sell some of their existing holdings. A worrisome precedent is the sharp decline in foreign sponsorship of [government-sponsored enterprise, or G.S.E.] debt since Fannie Mae and Freddie Mac were placed under conservatorship. Despite assurances from Treasury officials regarding the U.S. commitment to these institutions, foreign sponsorship has yet to return to pre-conservatorship levels. If foreigners began curtailing their investment in Treasuries as a result of a default, Treasury rates, and thus Treasury’s borrowing costs, would undoubtedly rise. A sustained 50 basis point increase in Treasury rates would eventually cost U.S. taxpayers an additional $75 billion each year.

Second, a default by the U.S. Treasury, or even an extended delay in raising the debt ceiling, could lead to a downgrade of the U.S. sovereign credit rating. Indeed, Standard and Poor’s decision to change the U.S. ratings outlook from stable to negative this week indicates a one-in-three chance that Standard and Poor’s will downgrade the U.S. rating within the next two years. One reason cited for the change in the outlook is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges. It is possible that a default, or even a delay in acting on the debt ceiling, will be perceived as an increased indication of the political inability to forge a compromise on essential long-term fiscal reforms. The consequences of a ratings downgrade would be significant, with the potential for Treasury rates to rise by a full percentage point for each one-notch downgrade.

Third, the financial crisis you warned of in your April 4th Letter to Congress could trigger a run on money market funds, as was the case in September 2008 after the Lehman failure. In the event of a Treasury default, I think it is likely that at least one fund would be forced to halt redemptions or conceivably “break the buck.” Since money fund investors are primarily focused on overnight liquidity, even a single fund halting redemptions would likely cause a broader run on money funds. Such a run would spark a severe crisis, disrupting markets and ultimately necessitating the same kind of backstops that Treasury and the Federal Reserve initiated in the aftermath of the 2008 crisis. Such further increases in Treasury’s off-balance-sheet commitments are likely to be viewed negatively by investors and ratings agencies, which will potentially put further downgrade pressure on U.S. sovereign ratings.

Fourth, a Treasury default could severely disrupt the $4 trillion Treasury financing market, which could sharply raise borrowing rates for some market participants and possibly lead to another acute deleveraging event. Because Treasuries have historically been viewed as the world’s safest asset, they are the most widely-used collateral in the world and underpin large parts of the financing markets. A default could trigger a wave of margin calls and a widening of haircuts on collateral, which in turn could lead to deleveraging and a sharp drop in lending.

Fifth, the rise in borrowing costs and contraction of credit that would occur as a result of this deleveraging event would have damaging consequences for the still-fragile recovery of our economy. In 2008, placing the GSEs in conservatorship combined with a tightening of credit standards caused mortgage spreads to widen by 1.5 percent, ultimately raising mortgage rates for consumers. A similar rise in mortgage and Treasury rates would adversely impact economic growth, potentially pushing the U.S. economy back into recession.

Finally, I would emphasize that because the long-term risks from a default are so large, a prolonged delay in raising the debt ceiling may negatively impact markets well before a default actually occurs.

This is no small thing. Seniors should know that when they get a letter saying there may be delays in getting their Social Security checks that it's the GOP playing politics with their lives. People looking at interest rates should know that the instability has been caused by the GOP deciding that harming Obama's re-election chances is the most important factor in this struggling economy. As we look at other institutions teeter on the brink of collapse, we should know that it is the GOP putting on the kabuki makeup.

But these roundtables never acknowledge from where this kabuki theater originates and why the GOP is making the calculus to do so.

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