What Happens If the U.S. Defaults on Its Debt?

    If the Treasury defaulted on its debt because Congress refused to authorize more debt this could hurt the world's capital markets.

It has been suggested that if the Treasury defaulted but then the default somehow led to Congress passing laws to improve the deficit that this would over the long run make Treasuries more attractive and increase their intrinsic value. However Treasuries are very unique. They are the world's benchmark for  the "risk free rate" used to calculate or benchmark various investment returns and contracts, etc. It is like the Naval observatory clock that sets a standard for measurement of time. It is a special entity that should not be tampered with.

A look at the politics

The political solution is for Republicans who have a goal of deficit cutting to simply wait until they have acquired more power in the 2012 elections. If the people, as of today, have not given them full power then they don't have the authority to engage in aggressive tactics to cut the deficit and will simply have to wait until the next election.

There is nothing like the U.S. dollar and the U.S. Treasury market. If the Treasury defaults it would be unprecedented for the issuer of the world's global reserve currency to default on it's bonds. There is no clear analogy or case history. It is not analogous to a large corporation filing bankruptcy because of the dollar's role as the world's reserve currency. Central Banks through out the world use the dollar instead of gold as a reserve asset. The dollar is merely a fiat currency with very little gold backing it. Respecting the value of the dollar is a matter of faith, since it is a fiat currency.

The history of the dollar

The dollar has benefited since WWII, or even since WWI, as a safe haven currency where it had an "exorbitant privilege" of being worth more than it should be due to a desire by foreigners to use it as a haven. This includes both the dollar as a currency and Treasury debt. What is hard to understand is how the Treasuries are in a unique class unlike any other debt that has existed in history. Any other sovereign or corporate debt with the U.S.'s problems would have long ago lost its safe haven and benchmark status and been downgraded. It is like someone who is a tribal shaman who is viewed by the masses as having magical powers, so the public lends money to this mystical shaman without reviewing his creditworthiness.

The U.S. should not do anything to shake up, or startle the world out of its slumber about the fact that the world's reserve currency is a fiat currency that has only a tiny amount of gold as reserves.

There is simply too much risk that some unknown economic phenomenon will occur if the Treasury defaults. Remember when the U.S. let Lehman go bankrupt how startled everyone was with the consequences? The analogy is that it was an unprecedented and unforecastable situation (by unforecastable, I mean the outcome of the bankruptcy, not the filing). I said there was no precedent to a U.S. Treasury default, but ironically an analogy is that a Treasury default would be so unprecedented that it would be analogous to the unprecedented default of Lehman.

The closest thing to the dollar's role as a reserve currency was the British Pound during 19th Century era. During that time Britain was very solvent, based on using income from its colonies to pay its debt, even though it had a lot of debt from the Napoleonic war. Further the Pound was then on the Gold Standard and thus was not comparable to today's fiat dollar.

When I say these gloomy words I am only talking about financial markets going into a traumatic experience. I expect that law and order will be enforced and law enforcement and military government employees will get paid and show up for work and retirement checks will get paid during a U.S. default.

Perhaps an analogy to that would be to have investments that are independent of the U.S. government: Emerging Market bonds.

About the author

Don Martin, CFP®

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