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.

Why Is California Collapsing ???

I.O.U.

Over the past couple of days I have come across two articles with very different diagnoses of California's fiscal crisis. One article, by Kevin O'Leary in Time Magazine, lays the blame for the crisis on Proposition 13, a Constitutional Amendment approved by California voters in 1979 that limits the property taxes that localities may levy. Because of Prop. 13, the argument goes, the state legislature must appropriate more and more money for projects and activities, such as public education, normally funded at the local level. As a result, the state has no little money left over for projects at the state level ordinarily funded by the state legislature.

A second article, by Kevin Hasset of the American Enterprise Institute, argues that California's troubles are the result "an orgy of spending" leading to its $26 Billion deficit. Having stated this conclusion, he then argues that California's experience is a cautionary tale for President Obama and his various expensive proposals.

O'Leary's hypothesis is shared by many, but it is only that, a hypothesis. Moreover, it is subject to a simple empirical test. The theory implies that states like California would derive less tax revenue overall, because of the Proposition 13 constraint, than states without such a restraint, thereby explaining the "gap" between spending and revenues in California. (After all, if California obtains more tax revenue from its citizens that other states, then the distribution of those receipt between state and local government should not logically impact the state's ability to provide services equal to the value of such revenues.) The theory also implies a subsidiary thesis, namely, that in California, local spending would constitute a smaller portion of overall state and local spending combined than in other states.

The data are inconsistent with both predictions and thus seem to falsify the O'Leary hypothesis.

According to the U.S. Census Bureau, California raised $236,646,725,000 in state and local revenue in during the 2005-2006 fiscal year, when its population was 36.1 million. That's $6,555 per person. (2005-2006 is the most recent year for which data are available at the census website.)  By contrast, during the same fiscal year, Utah raised $13,275,165,000, on a population of 2.5 million, for a total of $5,310 per person.

That is, California raised 23 percent more revenue per person than Utah in 2005-2006.

Utah, it should be noted, is not idiosyncratic. During the same period, Virginia, with a population of 7.5 million in 2005, raised $44,144,819,000, or $5867 per person, a figure closer to Utah than California. Indiana's tax revenue was also less than $6,000 per person. Here is the Census website, with the data on revenues and spending. 2005 population figures come from other reliable sources, e.g., Census press releases and a report from a think tank at UVA.

Note that a different source puts California per capita taxes in 2005 at $7,253.00, compared to $5,889.10 for Virginia, $5,811.8 for Utah and $5,710.10 for Indiana. Again, California's per capita spending is between 23 and 27 percent higher than that in Virginia, Utah and Indiana respectively.

What about the subsidiary thesis, i.e., that California localities will collect a smaller share of overall state taxes than localities in other states ? Here again, the data apparently contradict the O'Leary thesis. According to data on the same website listed above, California localities derive a LARGER share of overall state tax revenue than the localities in the other three states mentioned. Here are the figures, i.e., the percentage of overall state tax revenue taken at the local level, in the 2005-2006 fiscal year.

California 43 percent.

Virginia 41 percent

Indiana 41.8

Utah 36 percent.

Absent some equivalent to Proposition 13 in these three states, one must respectfully disagree with Mr. O'Leary' hypothesis. Spending, not some inability to tax, is the problem in California.

Note also that, from 1992-2004, a period with relatively low inflation, total state spending in California nearly doubled, according to from $123.9 billion, to $240.2 billion. It's hard to characterize California as a low tax state.