Watching the U.S. government’s debt ceiling crisis this week has been a little like standing outside your house as you watch it burn. The only question is whether the fire takes just the roof or burns your house to its foundation.
Congress has settled on legislation that would allow the government to fund itself beyond this week — putting the fire out, but not before significant damage was done.
True, the government should avoid a “default” on its obligations to make payments on its outstanding bills, notes and bonds, but there wasn’t much of a genuine risk that an investor would never get paid back after a Treasury note comes due. So maybe some of the most dire apocalyptic warnings in the past few weeks overstated the effects of a default.
What can’t be overstated, however, is how Congress may have diminished one of the country’s most valuable assets — the world’s near-universal belief that the U.S. Treasury’s obligations will be paid.
That faith may be gone forever.
A lot of people, here and abroad, have come to depend on that certainty of payment, as the $11.6 trillion U.S. Treasury market is the bedrock of global capital markets. When you read in the financial press that there is a “flight to quality,” it means that investors are getting nervous and have started selling — Bulgarian government bonds, Australian mining stocks, whatever they own — and buying U.S. Treasury securities.
Treasury securities are used for collateral on all sorts of loans and trading positions. They are the backbone of short-term lending in the capital markets through trades such as repurchase agreements. The yield curve for Treasury securities, a graph that marks the yield at various maturities, is how interest rates on other bonds are set.
Many of the most basic parts of finance, such as figuring out how to put a value on stock options, depend on the risk-free rate of return as a starting point.
Risk-free return meant the yield on U.S. Treasury securities.
The idea of credit risk has now been introduced into the trading of U.S. Treasury securities, and so something very fundamental has changed. How fundamental? If you don’t know what Treasury securities are really going to be worth, then you don’t know what anything will really be worth.
And when that happens, it’s called a financial crisis.
More than the bond market is affected by the erosion of the certainty that the United States will honor its obligations. The U.S. government is a guarantor or funder of a host of other programs, too. The promise to pay made by the most solid global citizen is also why the U.S. dollar is the world’s reserve currency, with more than 60 percent of foreign-exchange reserves globally denominated in the U.S. dollar, according to the International Monetary Fund.
The credit-rating agency Fitch Ratings put it this way earlier this week: “The prolonged negotiations over raising the debt ceiling … risks undermining confidence in the role of the U.S. dollar as the pre-eminent global reserve currency by casting doubt over the full faith and credit of the U.S.”
It’s no wonder the Chinese news agency this past weekend published a blistering editorial, saying “it is perhaps a good time for the befuddled world to start considering building a de-Americanized world.” After World War II, the United States became the protector of a well-functioning global market economy. Now what the world economy needs is to be protected from us. We can’t be trusted.
Trust is a fragile thing, and once it’s cracked it’s very difficult to repair. And to be fair, it’s just a crack. Treasury notes won’t start trading next week at 50 cents on the dollar.
But the certainty is gone, and if the U.S. government can’t be completely trusted to meet its obligations, then the pricing of all sorts of interest-bearing assets may need to be reconsidered. Transaction costs — what it costs to investigate and enforce transactions in a market economy — will likely rise.
Many of these effects will occur in markets most of us will never enter — in overnight trading done by people most of us will never meet.
But it’s going to affect real-world economic decisions we do care about, like capital spending by businesses and investments by foreign businesses in their U.S. operations. And isn’t economic growth challenging enough to get moving without Congress tossing gravel into the gearbox?