Thursday, October 10, 2013

Why even debating breaching the debt ceiling is a Big F*g Deal: a nonpartisan note

- by New Deal democrat

Regardless of your politics, you should care very much not just whether or not we actually fail to increase the debt ceiling, but that we are having the debate at all. Because simply having this debate is probably going to cost the US $billions, for years to come. Here's why.

Suppose you are a bond investor. You invest in sovereign bonds of country X. Country X has always paid its debts, so its bonds do not carry a risk premium. They are viewed as the equivalent as carrying around cash - but cash that pays interest.

Country X does have a quirk in its laws. Every now and then, on an irregular schedule, its legislature has to vote on whether or not to continue to pay it debts in timely fashion and in full, or to be a deadbeat. The question that the legislature votes on is, "Should we welch on some of our already existing debts? (a) Yes, (b) No."

For 100 years the legislature has always voted "no." Most often, the vote was pro forma. Sometimes, one or another faction made a show of disapproving of the debt level at which the country was operating, and so delayed the vote (but not the payments) for a few days, but after the brief dog and pony show, the vote was always the same: "no."

Twenty years ago, for the first time, there was a real donnybrook about what should be in country X's budget. The government actually closed down for about three weeks. And for the first time, there was talk of voting "yes" unless changes were made in the budget of country X.

As an investor in country X's bonds, you no doubt shrugged off this episode. It was a particularly nasty partisan show, but nobody seriously believed that country X was about to welch on some of the payments owed to you. It was a classic "one-off," you thought, and that was that.

But then, two years ago, one political faction in country X seriously suggested that country X should welch on some of its debts unless fiscal policies it wanted were implemented. A second big political faction in country X negotiated with them about that issue. For a brief while, it looked possible that the legislature might actually vote "yes" on that quirky question about welching on some debts. Ultimately, the political faction which suggested welching on some debts got some of what it wanted.

Now, only two years later, there is a repeat of the same fight, except now, it is even more serious. One political faction has indicated unequivocally that voting "yes" on that quirky question is a valid way of achieving fiscal leverage. This view appears strategically correct in the political sense, because last time the other political faction engaged in negotiations to alleviate the threat. Some members of the legislature have written newspaper or magazine articles, or given video interviews, indicating that welching on some debts to some creditors is really OK. Others have shown that they really have no clue about how your market operates, because they believe that if they are paying interest, even though they are missing principal payments, country X really isn't welching on its debts.

Let's assume that country X's legislature ultimately votes "no" on that quirky law again.

Do you, as a sovereign bond investor, continue to treat country X's bonds as cash, worthy of no risk premium?

The answer to that, I believe, is no, you don't. Threats to welch on country X's debt are no longer for show, and the serious threat to do so is no longer a one-off which will not repeat. In fact, it's quite clear that a dynamic has been put in place whereby a faction in country X can and will seriously consider voting "yes" on that quirky question unless it gets its way on unrelated issues. The legislature is increasing the frequency of when the vote on the quirkly law must happen, and the partisan battles over the quirky question are becoming more intense, more protracted, and the brinksmanship is increasing each time. Now you have even seen a significant share of the legislature declare that it is OK to stiff some of country X's creditors. Maybe you.

In short, the battles over welching on country X's debt are becoming more frequent and each time country X gets closer to actually welching. It appears that it is only a matter of time - and maybe not long at all - until country X actually welches on some payments of some debt.

So, you now want a risk premium, even though country X still has never missed even a single payment of interest or principal.

Turning now to the actual US situation, if the debt ceiling impasse is only put off a short time, like a few months, the dynamic of moving closer and closer to actual default is accelerating. It seems pretty clear that the rational investor will begin to insist that US bonds actually be assessed a risk premium. Even though the debt ceiling has never caused an actual default. That in itself ought to be a pretty sobering thought.