Loss of Risk-Free Status
By Arnold Kling
Even a temporary default would eliminate the safe and liquid nature of the U.S. Treasury market, harming this country’s ability to exercise its power, to the detriment of the U.S. and the global economy.
The main impact on markets would come from sharply reduced liquidity in the U.S. Treasury market, as financial firms’ procedures and systems would be tested by the world’s largest debt market being in default. Given the existing legal contracts, trading agreements, and trading systems with which firms operate, could U.S. Treasurys be held or purchased or used as collateral? The aftermath of the failure of Lehman Brothers should be a reminder that the financial system’s “plumbing” matters. All the legal commitments and limitations in a complex financial system mean a shock from an event that is viewed as inconceivable – such as a U.S. Treasury default – can cause the system to stall. The impact of a U.S. Treasury default could make us nostalgic for the market conditions that existed immediately after the failure of Lehman Brothers.
Treasury debt is supposed to be risk-free. Every economics textbook says so.
If Treasury debt ceases to be risk-free, the interest rate is going to go up. Also, investors will start to search for other assets to hold for safety. The problem is to find an asset that is stable in price, highly liquid, and widely available. I don’t see any asset that satisfies those criteria. If you think that the modern financial system (a) requires a high-volume safe asset in order to operate and (b) is a wonderful thing for the rest of the economy, then you have to view a default as Armageddon.
If you think that maybe our financial system is out of whack to begin with, and/or you think that the U.S. is bound to default eventually, then maybe we are better off having the default occur now. I would be willing to make that case. We have a financial sector that is built on the pretense that the U.S. is fiscally responsible, and we have a reality that says otherwise. The longer that everybody postpones the collision with reality, the more painful the collision will be, no?