Thursday, July 28, 2011

Conflicting Views at CNN Money About The Impact of the Debt Ceiling Deadlock on Interest Rates

Yesterday this blog took issue with the claim, made by President Obama and others, that failure to raise the debt ceiling will raise interest rates that ordinary Americans pay for things like car loans, home loans, and credit cards. (See this post). Unfortunately, a story on CNN Money earlier today continues to repeat some of the unpersuasive arguments this blog rebutted yesterday. Among other things, this new story quotes market "experts" to support the claim that a downgrade in the credit rating of the United States will somehow cause lenders to raise the interest rates charged to Americans whose creditworthiness has not changed. To be more precise, the article repeats the claim that, despite a downgrade, lenders will still treat US debt as the safest investment in the credit markets and thus the rates on such debt as the "baseline" for other rates, even if there are other investments that present lower risks.

As I explained yesterday, this argument assumes that lenders are irrational and ignores the fact that less borrowing by the United States will reduce the demand for credit and thus lower the price of credit, namely, interest rates. Imagine, for instance, that the rating agencies downgraded US debt to a CCC+ rating, driving rates on Treasury Bonds to 25 percent. Would lenders really charge individuals and businesses with AAA credit ratings MORE than 25 percent? Of course not, and lenders who tried such an approach would quickly lose business to those who charged rates that reflected the creditworthiness of individual borrowers.

However, it appears that reason is starting to prevail at CNN Money. Earlier today Chris Isidore weighed in on the question, in this article. Among other things, Isidore explains that failure to raise the debt ceiling could actually lower the interest rates on US Debt because less borrowing by the United States would reduce the supply of bonds, raise their price, and thus lower rates. (This is simply the flip side of the argument that less borrowing by the United States means less demand for credit and thus lower interest rates.) Isidore also argues that uncertainty created by the deadlock over the debt will actually cause investors to flock to Treasury Bonds, particularly insofar as the government will continue to raise sufficient revenue to pay the interest and principal on the debt, because such bonds are perceived as a sure bet. Finally, Isidore offers some modest evidence to support his argument, pointing out that the most recent auction of 7 year treasury notes produced a yield of 2.25 percent, the lowest on such notes since November. Of course, there are various determinants of such rates; low rates may simply signal that investors believe the economy and thus the demand for credit is weak. Still, such low yields seem inconsistent with an assertion that failure to break the debt ceiling deadlock by August 2 will produce an economic cataclysm.

Perhaps those who claim that the rate on US Debt is the benchmark for rates on private credit will now argue that the debt ceiling deadlock will REDUCE rates for private borrowing!!!

Tuesday, July 26, 2011

Will a (Very Unlikely) US Default Raise Interest Rates Paid by You and Me?

Needs a Crash Course on How Credit Markets Work

Might Become a Safer Bet Than The USA

President Obama and others are arguing that failure to raise the debt ceiling will raise the interest rates that Americans pay for mortgage loans, automobile loans and unsecured credit obtained via credit cards. (The President made the claim in his July 26, 2011 speech on the debt ceiling.) This argument is perplexing to say the least. If anything, failure to raise the debt ceiling will reduce interest rates applicable to private borrowing, whether or not that failure leads to default. Moreover, if the United States does default, rational self-interested creditors will continue to evaluate potential debtors in the same way --- by assessing the possibility of repayment --- and set interest rates accordingly.

Here's why.

1. It bears repeating that failure to raise the debt ceiling need not lead to default. The United States collects far more tax revenue each month than needed to pay the interest on the national debt. Thus, even if the debt ceiling remains fixed, the Department of the Treasury can prevent default by paying bondholders before making other expenditures. (See the following Op-ed in today's Philadelphia Inquirer by John Lott, explaining how the risk of default has been exaggerated.)

2. But let us assume that, contrary to logic and common sense, failure to raise the debt ceiling somehow leads the United States to default on its debt obligations. Certainly such a default will reduce the creditworthiness of the government of the United States and thereby reduce creditor confidence in US debt. Ratings agencies like Moodys and Standard and Poors would downgrade their rating of US Debt Securities. As a result, the national government would have to pay higher interest rates on any new debt it might issue if Congress were to subsequently increase the debt ceiling.

However, such a default will have no impact on the creditworthiness of individual Americans seeking to borrow money to purchase a home or car, for instance. (Why would your credit score fall if the United States defaults?) In fact, a failure to increase the debt ceiling and a resulting default by the United States might actually reduce the interest rates that ordinary Americans pay for credit. The interest rate, after all, is the price of credit, that is, the price of renting someone else's money. Like other prices, this price is determined by supply and demand. If Congress refuses to increase the debt ceiling, the United States will reduce its borrowing and thus its demand for credit, thereby reducing the interest rates paid by those entities (households, businesses, states and other countries) that continue to borrow. Even if Congress does eventually raise the debt ceiling and thereby authorize new borrowing by the United States, individuals, firms and states might still pay lower rates than before, as some creditors prefer lending to such entities over the United States.

3. Nonetheless, some news outlets continue to push the idea also advanced by the President that a default would raise interest rates paid for private credit. These outlets argue that banks and other financial institutions tie the interest rates on some loans to the interest rates on US Government Debt. If those rates rise, the story goes, so will rates on purportedly less secure debt incurred by private individuals.

Thus, according to one story on MSN Money:

"Treasury bonds provide the floor for other lending --- car and home loans, credit card debt and student loans, for instance. And because those loans are seen as more risky, the interest charged on them is higher and could rise faster than the increase in the rate on US Securities.

This prediction does not withstand scrutiny. Less charitably, the statement is economic balderdash. Certainly Treasury Bonds currently provide the floor for other lending, for the simple reason that such securities are perceived as safer bets than all other investments, whether AAA-rated state bonds, unsecured credit card loans or car loans. However, if the United States government defaults, creditors, as rational actors, will no longer treat such bonds as the safest possible investment, with the result that US Government debt will, by definition, lose its status as the "floor for other lending." Instead, creditors will presumably identify a different debt security as the safest bet and thus the "floor for other lending." For instance, creditors might choose the debt of states like Virginia, which currently enjoys a $300 million budget surplus and a long-standing AAA bond rating, as a benchmark. Or, creditors could choose a "market basket" of the debt of several states and/or well-managed private firms. In any event, if the United States government defaults, profit-seeking creditors, who operate in a competive capital market, will continue to judge other debtors the old fashioned way, that is, by assessing the prospect that such borrowers will pay back the loan in question. Those who do not, that is, who charge rates higher than justified by the risk presented, will rapidly lose business to those who do. Moreover, those borrowers who, like the Commonwealth of Virginia and millions of ordinary Americans, manage their affairs wisely will be rewarded.

UPDATE (6:30 PM Thursday, July 28): An hour or so ago CNN Money published a story repeating some of the arguments rebutted here. I discuss that story, as well as a better-reasoned story on CNN Money, in a subsequent post --- here.

Sunday, July 3, 2011

Another Founding Father For Abolition

American Aristides and Abolitionist

The Economist magazine has waded into the controversy, born as a dispute between ABC's George Stephanopolous and presidential candidate Michele Bachmann, over the extent to which the American Founders worked to end slavery. As many know, Stephanopolous argued that the Founders did not work to end slavery, while Congresswoman Bachmann claimed they did, citing only John Quincy Adams, a young boy at the time of the Revolution, as an example.

In a piece entitled "John Jay Saves the Day," The Economist has offered some support for Congresswoman Bachmann's assertion, contending that: "[p]lenty of founders did fight hard to end slavery." At the same time, the essay asserts that "the really good guys on slavery were not" Washington, Jefferson and Madison, but instead "less venerated big government Yankee founders who sped the abolition of slavery in the North." As examples, the essay cites Alexander Hamilton and John Jay of New York and Gouverneur Morris of New Jersey. The piece praises Jay, himself a slave owner, for purchasing slaves and then granting them freedom after what Jay deemed a reasonable period of time. The piece also praises Jay for signing a 1799 New York "Act for the Gradual Abolition of Slavery." The Act provided that, beginning on July 4 of that year, all children born to slave parents in New York would be free. The Act also prohibited the export of slaves from New York.

The Economist is certainly right to praise Jay, Hamilton, and Morris for their opposition to slavery and their efforts to combat it. Hopefully Congresswoman Bachmann and George Stephanopolous will "stand corrected" and give these gentlemen their due. However, the Economist errs when it suggests that only northern Founders fought to end slavery, failing, as it does to mention George Wythe of Virginia, a prominent Founder and Abolitionist.

Wythe is perhaps best known as the first Professor of Law and Police ("policy") at the William and Mary Law School, founded as the nation's first law school in 1779. (Wythe served in this capacity until he resigned in 1789.) Less well-known is his role in the American Independence Movement and adoption of the U.S. Constitution. He drafted the Virginia Legislature's Resolution in Remonstrance, protesting the Stamp Act, in 1764. Elected to the Continental Congress in 1775, Wythe voted for the Resolution of Independence, moved by fellow Virginian Richard Henry Lee, and signed the Declaration of Independence drafted by Jefferson. He then served as Speaker of Virginia's House of Delegates from 1777-78. He was a member of the Virginia Court of Chancery for more than two decades. In the so-called "Case of the Prisoners" (Commonwealth v. Caton, 1782) Wythe issued an opinion claiming the power to invalidate unconstitutional statutes, thereby presaging the doctrine of judicial review articulated by his student, John Marshall, in Marbury v. Madison, 5 U.S. 137 (1803).

Wythe also attended the Philadelphia Convention that drafted and proposed the U.S. Constitution. George Washington, who presided, appointed Wythe, along with Hamilton and Charles Pickney, to a committee charged with developing procedures to govern the Convention. However, he left the convention early and did not sign the document. He did, however, participate as an elected member of the Virginia Convention that voted to ratify the proposed Constitution.

Like the northern Founders extolled by the Economist, Wythe was an abolitionist. He freed his own slaves and provided for their support, teaching Ancient Greek to one former slave who continued to live with Wythe in Richmond. Moreover, as a Judge in the District Court of Chancery in Richmond, Wythe ruled that the Virginia Declaration of Rights created a presumption that all men were free, regardless of their race. (Unfortunately, an appellate court reversed this portion of Wythe's opinion.) No doubt Wythe's example helped inspire the other Virginians who freed their slaves in the post-Revolutionary period. Perhaps Wythe's example also inspired his successor at William and Mary, St. George Tucker, to craft his "Plan for the Gradual Abolition of Slavery" published in the mid-1790s.

It is little wonder that Wythe's biographer called him the "American Aristides," a reference to the Athenian leader whose moderate assessment of tribute owed by members of the Delian League helped earn him the title of "the Just."

Hopefully the Economist, George Stephanopolous and Congresswoman Bachmann will "correct the record" and recognize Wythe's role in helping eradicate human slavery in the United States. July 4th would be a perfect day to start!