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.