The default has already begun

Written by Reuters | Updated: Oct 17 2013, 09:25am hrs
Felix Salmon

The big question in Washington this week is whether, in the words of the NYT, were going to see a legislative failure and an economic catastrophe that could ripple through financial markets, foreign capitals, corporate boardrooms, state budget offices and the bank accounts of everyday investors. In this conceptionand I have subscribed to it just as much as anybody elsethe sequester is bad, the shutdown is worse, and the default associated with hitting the debt ceiling is so catastrophic as to be unthinkable.

This frame is a useful one, not least for the politicians in Washington, who seem to have become inured to the suffering caused by the shutdown, and downright blas about the negative consequences of the sequester. Both of them could last more or less indefinitely were it not for the debt ceiling, which is helpfully providing a hard-and-fast deadline: Congress is going to have to come up with a deal before the ceiling is reached, because the alternative is, well, the zombie apocalypse.

Theres more than a little truth here: Im a firm believer, for instance, that the president both can and should prioritise debt repayments in the event that the debt ceiling is reached. If were going to be so stupid as to hit the ceiling, then prioritising debt service is the least-worst outcome. But at the same time, the situation is less binary than it looks, not least because the US government is already in default on its obligations.

The best way to look at this, I think, is that theres a spectrum of default severities. At one end, you have the outright repudiation of sovereign debt, a la Ecuador in 2008; at the other end, you have the sequester, which involves telling a large number of government employees that the resources which were promised them will not, in fact, arrive. Both of them involve the government going back on its promises, but some promises are far more binding, and far more important, than others.

Right now, with the shutdown, weve already reached the point at which the government is breaking very important promises indeed: we promised to pay hundreds of thousands of government employees a certain amount on certain dates, in return for their honest work. We have broken that promise. Indeed, by Treasurys own definition, its reasonable to say that we have already defaulted: surely, by any sensible conception, the salaries of government employees constitute legal obligations of the US.

Conversely, if you really do expect zombies to start roaming the streets the minute that the US misses a payment on its Treasury obligations, youre likely to be disappointed. Yes, the stock market would fall. But the price of Treasury bonds would remain in the general vicinity of par, and it might even go up if Treasury announced that past-due interest would be paid on all debt at a statutory rate of 8% per annum. Even when its Treasury bonds themselves which are the instruments in default, Treasury bonds remain the worlds flight-to-quality trade, and the expected recovery on all defaulted Treasury obligations would be 100 cents on the dollar or more.

The harm done to the global financial system by a Treasury debt default would not be caused by cash losses to bond investors. If you needed that interest payment, you could always just sell your Treasury bill instead, for an amount extremely close to the total principal and interest due. Rather, the harm done would be a function of the way in which the Treasury market is the risk-free vaseline which greases the entire financial system. If Treasury payments cant be trusted entirely, then not only do all risk instruments need to be repriced, but so does the most basic counterparty risk of all. The US government, in one form or another, is a counterparty to every single financial player in the world. Its payments have to be certain, or else the whole house of cards risks collapsing starting with the multi-trillion-dollar interest-rate derivatives market, and moving rapidly from there.

And heres the problem: were already well past the point at which that certainty has been called into question. Fidelity, for instance, has no US debt coming due in October or early November, and neither does Reich & Tang (as reported by the WSJ):

While he doesnt believe the US will default, Tom Nelson, chief investment officer at Reich & Tang, which oversees $35 billion including $17 billion in money-market funds, said that the firm isnt holding any US securities that pay interest at the end of October through mid-November because if a default does take place, wed be criticised for stepping in front of that train.

The vaseline, in other words, already has sand in it. The global faith in US institutions has already been undermined. The mechanism by which catastrophe would arise has already been set into motion. And as a result, economic growth in both the US and the rest of the world will be lower than it should be. Unemployment will be higher. Social unrest will be more destructive. These things arent as bad now as they would be if we actually got to a point of payment default. But even a payment default wouldnt cause mass overnight failures: the catastrophe would be slower and nastier than that, less visible, less spectacular. Were not talking the final scene of Fight Club, were talking more about another global credit crisiswhere credit means trust, and trust means trust in the US government as the one institution which cannot fail.

While debt default is undoubtedly the worst of all possible worlds, then, the bonkers level of Washington dysfunction on display right now is nearly as bad. Every day that goes past is a day where trust and faith in the US government is evaporatingand once it has evaporated, it will never return. The Republicans in the House have already managed to inflict significant, lasting damage to the US and the global economyeven if they were to pass a completely clean bill tomorrow morning, which they wont. The default has already started, and is already causing real harm. The only question is how much worse its going to get.