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!!!