Kevin Drum is puzzled by default panic:
If we run out of money, the federal government will stop paying some of its bills. That’s bad, and it will quite likely have a negative effect on the economy. Corporations are right to be apprehensive about this.
But that’s all that will happen. Treasury bonds will continue to roll over and interest payments will continue to be made. That means there’s no reason to sell Treasurys; no reason they can’t continue to be used as collateral; no reason that access to capital should dry up; and no reason that companies will need more cash.
At least, that’s how it seems to me. What am I missing here? I feel like I must be an idiot or something. Is the answer something so obvious that no one ever mentions it, or something so arcane that it never gets explained in lay terms? Or is everyone else crazy? Or what?
I have a rather cynical “or what” to offer in response, which is this: Contrary to the last few decades of Wall Street propaganda, the people who run these things just aren’t all that bright. They’re every bit as stupid and gullible as the general public, maybe even a bit more so.
I mean, look at the last couple of decades of financial history: int he late 1990’s, we had the tech bubble, where the geniuses on Wall Street managed to convince themselves that companies with no income and no obvious way to generate income were worth vast sums of money. Only, not so much.
Then we had the housing bubble, where they managed to convince themselves that there was absolutely no risk inherent in loaning large sums of money to people with no ability to pay it back. Only, not so much.
In the wake of the housing bubble popping, we had the opposite problem: for a while, nobody would lend any money to anybody, because they were suddenly convinced that everything was insanely risky, on the basis of about as much evidence as their previous convictions that garbage loans were rock-solid and that every college dropout who knew a few HTML tags was a genius who deserved a few million in venture capital.
At some point, we collectively need to face up to the fact that the financial wizards of the world are basically indistinguishable from any randomly chosen pack of idiots. The fact that they use lots of math to convince themselves of blindingly stupid things doesn’t make them any smarter than any of the rest of us. It just makes them differently stupid.
William F. Buckley famously said that he’d rather be ruled by the first hundred names in the Boston phone book than the Harvard faculty, and over the last fifteen years, I’ve become convinced that the same is true of the business world generally. If you marooned all the CEO’s and financial analysts in the country on an island somewhere, and filled their jobs with randomly chosen members of the public, I doubt you’d see much of a difference in the functioning (or lack thereof) of the economy. I suspect you could probably replace most of the bond rating agencies with chimpanzees without producing any significant effects.
Decades of self-serving books and op-eds and worshipful media treatments have tried to convince everyone that the people running major corporations and Wall Street investment houses are somehow better than the rest of us– smarter and more savvy, with some deep insight into the way the world works. Which is why, when they do things that make no sense at all, we waste lots of time scratching our heads and trying to find some angle on the situation that makes their actions look reasonable.
In the end, though, I’ve come to think that when people on Wall Street do something that seems to make no sense at all, that’s because it makes no sense at all. Because, collectively, they’re a pack of idiots, and just as prone to being dumb, skittish, or gullible as anybody else.
Which would be fine, except they command vastly more resources than anybody else, so when they do something blindingly stupid, they break the entire world economy. Which is, ultimately, why they should be taxed and regulated to within an inch of their life, because while setting idiots free to do whatever they like with vast sums of money will sometimes pay off, when they go wrong, they wreck everything.
The old saying “If you put all the economists in the world end to end – they still couldnt reach a conclusion” seems to apply.
Stupid? Really?
Yes, they may destroy the world’s economy, but who ends up with all the money? They may not understand how the world works, but they sure understand how to line their own pickets.
…and pockets, too.
I’m puzzled as to why Kevin Drum is puzzled. As I understand it, the debt ceiling is like a limit on a credit card. What happens when you’ve reached you limit and you present your card for payment? It gets declined; the payment isn’t made.
How does he expect interest payments to be made or bonds to roll over without access to more money? If I’m a bond holder and I’m due a payment on, say, Aug 15, what happens? What happens when I get no money? If it’s another business that doesn’t pay me, I think about how that relationship will change in the future. Will I be as eager to invest? Will I expect a higher rate of return since I didn’t get paid on time the last time I dealt with them? And how does this ripple effect all the people I owe, who I cannot now pay on time?
I don’t know how this will ultimately affect the US and world economies but it cannot be a good thing. Maybe we won’t have doom and gloom but we will slow down some more and this mild recovery will be stalled once again. And while all this is going on, no jobs are being created.
I agree that those in charge of the financial sector are no geniuses but I’m afraid that that condition extends well beyond Wall St.
T. Hunt
I have a simpler response to Drum’s “Or what?” Specifically, he has no idea what he’s talking about.
Never mind outright default, let’s assume that there’s no deficit deal and that the ratings companies downgrade us from AAA to AA, as they’ve threatened to. Interest rates probably go up for everyone which, contrary to what Drum says, is exactly reduced access to capital, by virtue of it becoming more expensive.
Likewise, yes, you could still use T-bills as collateral, but that collateral will be worth less because of the lower rating, reflecting greater risk.
At the 50,000 foot level, finance is a tool for managing, or working around, risk and uncertainty. Works fine, if, but only if, most of the parties involved have a good handle on the risks and uncertainties. Here, we’ve had rock solid, perfect credit for almost 95 years. Almost no one living remembers when we didn’t. Even fewer (possibly actually zero of those people) are active in finance in any meaningful way, anywhere in the world, not to mention, the world has changed a little in the last 95 years.
No one knows what the result would be, exactly, but that is exactly the definition of risk and uncertainty on which no one has a good handle.
Drum makes the quintessential pundit mistake of assuming that everyone, everywhere will react exactly like him.
In this case, even though he is responsible for the vast finances of his checking account, while other people might be responsible for only the small financial set-ups of huge pension funds or Fortune 500 companies.
Existing bonds carry on. Unaffected mostly by any rise in interest rates because they are fixed coupons.
New bonds – well debt ceiling, so no new bonds there.
That leaves bonds that mature. Presume the US wants to borrow up to the debt ceiling, they need to issue new bonds to replace the matured ones. They will be at a new rate.
Now, does scarcity kick in, in which case the new bonds will have a lower coupon?
With a new fiscal reality and the US not borrowing hand over fist, the probability of default recedes. Rates will come down as a result.
Lets face it, the law in the US says no new debt, no tax rate rises. More fool Obama for putting forward large spending promises.
I’m puzzled as to why Kevin Drum is puzzled. As I understand it, the debt ceiling is like a limit on a credit card. What happens when you’ve reached you limit and you present your card for payment? It gets declined; the payment isn’t made.
How does he expect interest payments to be made or bonds to roll over without access to more money?
Hitting the debt limit doesn’t mean the government is out of money, it means that they can’t borrow any more money. They can still pay interest and pay off bondholders, but that money has to come from something else– from stopping one of the other money-consuming functions of the government. Kevin’s making the very reasonable assumption that the Treasury will make their first priority paying interest on the debt and paying bondholders, and take the money from something else– shutting down government offices and the like.
I mostly agree with this post, but I have a couple of quibbles.
One is related to T. Hunt’s point above. Certain investment vehicles are set up with rules requiring them to invest in securities with AAA ratings (rated, admittedly, by the same idiots who thought that mortgage loans made to people who lacked the ability to pay the principal were, as they used to say, safe as houses). During the RE bubble years these vehicles were suckers for securities based on these mortgages, sliced and diced until some fraction of them could be pronounced safe enough to carry a AAA rating. Now, they are in Treasury securities.* If the US government’s credit rating is reduced (which would be justifiable if the US actually does fail to increase the debt ceiling), these vehicles would have to dump their Treasury holdings, as well as any municipal bonds in their portfolios (for obvious reasons regional and local governments cannot have a higher rating than their national government). Certain Wall Street firms are preparing to profit in exactly this way: buy cheap Treasury securities from investment vehicles that have to sell at a loss.
The other quibble is this: “At some point, we collectively need to face up to the fact that the financial wizards of the world are basically indistinguishable from any randomly chosen pack of idiots.” Actually, there is a difference: Wall Street (as well as the City of London, and probably also the Tokyo equivalent) tends to recruit almost exclusively from certain elite universities. It’s possible to get to Wall Street with degree(s) from State U., but it’s a lot harder. Conversely, many people with degrees from these institutions go on to jobs outside the finance sector. But you will find a much higher than average percentage of grads from any given elite university on Wall Street.
*There is possibly another bubble in progress here. From perusing the Calculated Risk comment threads I understand that sovereign debt, which would include Treasuries, is considered risk-free for certain purposes up until the day that government defaults on its debt.
They can still pay interest and pay off bondholders, but that money has to come from something else
Yes, they can, in the sense that it does not break the laws of physics; the money (so far as I understand it) does exist.
That’s less important than Drum thinks it is, because credit rating agencies don’t rate credit on what can happen, but what (they judge) is likely to happen.
Having a trillion dollar per year hole in government finances is unprecedented. Having a hole in government finances this large as a percentage of government receipts is unprecedented for the United States, which makes it unprecedented.
Consequently, the ratings agencies don’t know what’s going to happen, either; that being the definition of uncertainty, they’ll be obligated to rate the government downward even though that downward rating will itself increase the uncertainty of the situation. If they don’t, everyone will assume the ratings agencies play by different rules for the US Government, and the ratings agencies will suffer.
(The ratings agencies have been pretty clear that they’re not just worried about immediate default, either, but about the entire structure and sustainability of government finances for the next 10 to 20 years going forward, too.)
“As I understand it, the debt ceiling is like a limit on a credit card. What happens when you’ve reached you limit and you present your card for payment? It gets declined; the payment isn’t made.”
Not exactly. When the Treasury sends out a check, it’s paid from the general fund account maintained by the Fed. What happens when the account balance is zero? No one really knows. Would the Fed bounce a Treasury check? It seems unlikely they would, but there would be legal impediments to an overdraft (the Fed is prohibited by law from making direct loans to Treasury), but in this environment it’s not clear that the Fed would stand on legal formality if the credit of the US were on the line.
@Nick – the issue is not any “spending promises” made by Obama.
The authorization and appropriation of funds is the constitutional duty of the House of Representatives.
Further, there is Nixon era precedent that the Executive must spend appropriations, they can’t pocket line veto authorized and appropriated spending.
So, what happens when the cash flow is inadequate, and there is no authorization to issue additional debt?
Something has to give. No one quite knows what.
Most people think debt repayment and interest payments are senior to current expenses.
Some people think the authorize/appropriate obligations, combined with the 14th amendment override the law on the debt ceiling and the Treasury can break the ceiling.
After that: they stop construction, then non-critical cash flow, like payments to agencies, starting with science – so no NIH, NSF, DoE, NASA outflow etc.
They also stop transfer payments to states and municipalities.
Then it gets interesting – like do you pay Medicare providers? or Social Security? Does defense have priority? Arguably it has constitutional priority, but which parts? Pensions? Current payroll? Contractors?
Fear. Uncertainty. Doubt.
Basically, what Eric Lund said. Except I think that the funds requiring AAA investments own a lot more treasury bonds than his comment indicates.
My understanding is that funds such as pension funds require such no-risk investments. Remember that the majority of US federal debt is not held by China or Saudi Arabia or Kuwait but by Americans. Mostly in pension funds and various forms of annuities. I work for an insurance company, we own a lot of treasury bonds because our rules for how we manage our reserves require us to hold rock solid paper.
If the US defaults on even part of the debt, and probably even if they don’t default but are downgraded. then those funds would be required to move the money. That’s a HUGE amount of money. Unprecedented even. Where would it all go?
The disruption is probably incalculable.
Mike.
“I suspect you could probably replace most of the bond rating agencies with chimpanzees without producing any significant effects.”
That has actually been tried. Chimpanzee won: http://www.dailymail.co.uk/news/article-1242575/Lusha-monkey-outperforms-94-Russia-bankers-investment-portfolio.html
Which is actually not that surprising. A good random number generator consistently _wins_ against most of humans in rock-paper-scissors. We are wired to see patterns where there is none.
Nit pick:
The housing bubble was caused by loaning much more than the property was worth. A borrower defaulting on a loan is no problem if the bank gets valuable property as a result. An article in “The New Yorker” a few years back (about Tampa area) documented the stupid (possibly fraudulent) actions that took place.
@5:
We will still pay our bonds, so there is absolutely no reason to change their rating. That S&P or Moodys are talking about this is an example of the idiocy Drum mentions. There may be a reason to change the ratings for many companies, however. See below.
@4 (and the weak reply @7):
If you are using a credit card without any income, ever, that would be a relevant example. But you aren’t, so it isn’t. The example is that you hit your limit AND your bank account is empty except for IOUs (that are, more precise, IOIs) so you have to operate entirely on cash.
Watch that Canadian woman straighten out people’s budgets as an example. What do you do? Well, you make minimum payments and interest on your debts and then budget the rest to deal with, say, a 40% cut in income. House payment, electricity, food. Turn off the AC. (That would be my first step in the Capitol.) Cancel phone and cable and stop eating at restaurants or going to movies. Buy only what is on your shopping list, and buy school clothes at Goodwill. Etc.
As I wrote at Dean Dad’s this morning, the President might get the Elephant’s owners attention if he put up a NO-PAY list for August if the limit is hit. Will he choose to pay Lockheed and Boeing or air traffic controllers and airport security? Medicaid or farm subsidies or the VA or Pell Grants, or none of the above? Hint: in the case of the US government, entitlements make up a majority of the budget. There is a reason the Republican House did not pass a balanced budget bill this year.
CCP @14:
Your reply implies to me that you think the bond rating depends only on the opinions and actions of perfectly calm, perfectly coordinated economic actors. And you seem to be thinking about this over maybe a two-week horizon past August 2.
Let me be blunt: That’s not at all how it works.
The actors in this scenario are not merely economic, they are also political. Second, as this drama unfolds, they will be neither calm nor coordinated. They will be frightened and in many cases in very real pain.
And while I also believe that the bond holders will get paid, that means a whole lot of other people won’t. That might shock the body politic to its senses and end the crisis. Or it might bring out more of the same feelings we saw in the wake of TARP, with people demanding to know why some fatcat creditors are getting paid while real people are suffering and thinking maybe they should vote in someone who cares about them over some faraway billionaire creditor…. We saw a lot of that sentiment in 2008, so it’s not like it’s that far below the surface or anything.
Now, I am emphatically not making a prediction on this. I don’t know any more than you do what’s actually going to happen. Hell, maybe my next angry phone call (to my jackass 8th district Representative) will be the final straw, sense will break out, and the problem will be solved tomorrow.
But I know that I don’t know; I know that this is the definition of uncertainty; and I know that this uncertainty is a large part of what the ratings agencies actually rate.
John @15:
If you are arguing that the bond rating agencies would act irrationally, you are making Kevin Drum’s original point as well as mine. The only rational reason for downgrading US treasuries is if you have objective evidence (not lunatic ravings) that the US will not pay interest and/or interest on them out of its current income stream. This is easily addressed, and (if you look at any bond market) clearly has already been addressed to the satisfaction of investors.
I agree 100% that other “people” most definitely will not get paid. There will be massive layoffs of government employees and some contracts would be suspended. If you think they will shut down or limited air traffic, the stocks and bonds of Fed Ex, UPS, and airlines should be downgraded. If you think major defense contractors will not get paid, their stocks and bonds should be downgraded.
Even Starbucks and McDonalds would be hit hard if 40% of the budget stopped flowing.
I’m surprised that no one is asking about the ratings of those companies rather than the ratings of T-bills.
I don’t think the major entitlements will be cut off, but Medicaid payments to the states (and other forms of Nixon’s “revenue sharing”) would be likely to keep the military paid and airports open.
Editing error – meant to write “principal and/or interest”
CCP @16: I’ll admit that I have no clue how S&P or Moody’s arrives at their credit ratings, and I suspect that neither you nor John know either. But I can observe the output of that black box, and I see cases where there is no evidence a default is being seriously contemplated yet the rating is somewhere below AAA. Japan is one example: they have never failed to pay principal or interest on their bonds, and there is no evidence that they ever intend to stop paying (they, like most countries and unlike the US, have no debt ceiling), but their rating is only AA. Many European governments–not just the PIIGS, either–have lower ratings. The reason ratings between AAA and default status exist is that the ratings agencies aren’t considering just the evidence that a default is imminent, but also the perceived risk that default might occur at some future date. Failure of Congress to raise the debt ceiling might reasonably be interpreted as implying a higher risk of default at some future date.
You are correct that the bond vigilantes have remained invisible thus far. Investors seem not to believe that anything bad will happen (or alternatively, that there is nowhere else to run). That doesn’t mean there is no risk of bad things happening. The recent financial crisis, featuring AAA rated toxic junk, should be ample evidence of that.
CCP @16:
No, I’m not saying the ratings companies are irrational. I’m saying that they need to rate the credit worthiness of a government whose polity is heading toward a period of great pain and therefore potential panic and irrationality. Certainly, toward a period of economic instability and– I’ll keep saying this until it registers– uncertainty.
Eric @18 is exactly correct– this is not a binary Default-next-week, not-default-next-week situation. If they actually thought we were going to default next week, our credit would be junk, like Greece. But, they need to give some sort of credibility rating going out thirty years. And that, in the likely environment absent a debt deal, they can’t give out a AAA rating for that horizon.
Two more things: First, I have no doubt that McDonalds, Starbucks, and others are in for a rough time. But why do you think they’re not worried about their own ratings? Do you not see the weekly, now daily, now hourly warnings in the news from various corporate concerns about what’s going to happen to the economy? They are the economy.
Second, Eric’s comment about the lack of anywhere else to run has something going for it. I’ve seen credible people make the argument that the global economy is too hardwired into the United States, and the flows of money are too large, to be taken out and placed anywhere else.
That might be true. It’s in some ways a comforting thought, relative to everywhere else. But only in a relative sense. In an absolute sense, it just means a global economy that’s seriously out of whack.