As the country lurches toward a showdown over the deficit and the debt ceiling, one argument has come up that is especially worrisome. There are those who say that a short-term temporary default (or “technical” default) would not be damaging. If you look just at the amount involved, that is probably correct. But the amount involved is only a small part of what is at stake. The issue is not about the financial capital but reputational capital. In a piece in the Wall Street Journal last week (What Happens if U.S. Defaults?), Maury Harris, chief U.S. economist for UBS Investment Bank, and Drew T. Matus, senior U.S. economist, UBS Investment Bank, laid out what is a stake:
The U.S. occupies a special place in global finance. The symbiotic relationship between the U.S. dollar as a reserve currency and the U.S. Treasury market’s monopolistic position as the safest, most liquid bond market in the world has served this country well. This unique position has allowed the U.S. to exercise significant authority in the global economy and enhanced its standing as a world power. Even a temporary default would eliminate the safe and liquid nature of the U.S. Treasury market, harming this country’s ability to exercise its power, to the detriment of the U.S. and the global economy.
. . .
if the political impasse continues and the U.S. defaults, it would not simply be a question of whether Treasury investors would get their money; eventually they would. It would be a question of whether the U.S. would lose something that made it special. The answer would be yes and the consequences for U.S. growth could be significant.
The main impact on markets would come from sharply reduced liquidity in the U.S. Treasury market, as financial firms’ procedures and systems would be tested by the world’s largest debt market being in default. Given the existing legal contracts, trading agreements, and trading systems with which firms operate, could U.S. Treasurys be held or purchased or used as collateral? The aftermath of the failure of Lehman Brothers should be a reminder that the financial system’s “plumbing” matters. All the legal commitments and limitations in a complex financial system mean a shock from an event that is viewed as inconceivable – such as a U.S. Treasury default – can cause the system to stall. The impact of a U.S. Treasury default could make us nostalgic for the market conditions that existed immediately after the failure of Lehman Brothers.
Post-default liquidity could get even worse in the likely event of a rating downgrade. The liquidity event would not be limited to the Treasury market. Any reduction in the ability to use Treasury debt as collateral for loans would mean funds would need to be found: liquid assets sold to raise cash. Additionally, holders of U.S. Treasurys counting on timely payment could be forced to borrow funds in upset credit markets when those funds do not materialize.
What they don’t talk about is how long it would take to get back to near normal – if at all. Once lost, reputational capital is very hard to regain. Once US Treasurys are no longer the foundation of the financial system, can they ever be again?
Let us hope that this is a question we will not be asking come the beginning of August.