Will The United States Default? That Depends on How You Define “Default”

| June 03, 2023

It’s that time of season again, when politicians arbitrarily and irrationally manipulate what should be an automatic procedural mechanism regarding the nation’s borrowing capacity to instead extract concessions and push agendas they were not able to pass in Congress.

Speaking of “arbitrary”, the debt ceiling itself is arbitrary and the country would likely be better off if the debt ceiling were eliminated. The only other country with a debt limit somewhat similar to the USA is Denmark, but their debt limit doesn’t lead to unnecessary political machinations like it does here in the US. I say “similar” because several other countries have debt limits, but are linked to GDP and so are automatically adjusted. The debt ceiling was created in 1917 as a solution to the Treasury’s requirements to fund World War I quickly and efficiently as opposed to the previously slow process that involved incremental spending requests that needed to be approved piecemeal by Congress. 

Perhaps the most ludicrous aspect of this whole charade is that the spending that will potentially be affected due to the debt ceiling debate was already approved by the very Congress that is now fighting over whether to raise the debt limit. They approved the spending, but apparently aren’t willing to fund it. The time for debate regarding government spending is before the spending is approved, not after. As of June 3, a deal was made and both sides are claiming victory. However, politicians only pushed the can down the road a couple of years until the next time this issue is used for political gain. 

So, will the US default in the future when politicians inevitably pull this stunt again? That depends on your definition of the word. The payments that matter to everyday individuals like social security benefits, medicaid payments, federal salaries, veterans’ benefits, and others are likely to be delayed, but the priority of those payments is up to the Treasury. Unlike a government shutdown, with a debt ceiling roadblock, the spending for federal programs and agencies is already decided, but then it’s a matter of actually being able to disperse funds. 

So yes, in a couple of years when this situation arises again, we might see delays in payments if no deal is reached at that time. However, that’s not really a default and it’s not the default the financial markets care about. The most important and impactful disbursement the Treasury makes is interest payments on outstanding national debt. Unlike the relatively benign (I use this word loosely, because it’s certainly not benign for the public welfare) consequences of temporarily delaying social security benefits or other payments mentioned above, missing even a single interest payment would be absolutely catastrophic for the bond market, the national economy, and the international monetary system as a whole. The likely outcome for even one missed interest payment would likely be a shift along the entire yield curve for US debt. As a visual illustration of what this might look like, the graph below shows a typical yield curve with interest rates (yields) on the Y-axis and maturity on the X-axis. The black line would be an example of the yields on US debt prior to a missed interest payment (default) while the orange line represents the yield curve after a default.


Source: https://www.financetrain.com

The explanation for this shift is simple: credit risk/default risk. As with all bonds, government and private, there are inherent premiums included in the interest rate to account for the investor (bondholder) taking on risk by purchasing the bond. Some of these risks include inflation risk, interest rate risk, and credit/default risk. The credit/default risk represents the risk that the bond-issuer may not make interest or principal payments on time or at all. With US government debt, that risk premium is essentially zero and has been zero for decades. A missed payment by the US Treasury would spook the bond markets and suddenly every form of US debt, both long and short, from the 1-month T-bill to the 30-year T-bond, would suddenly include a default risk premium and interest rates would spike across all maturities. 

It’s true the Federal Reserve has a major impact on the bond market and theoretically they, in tandem with the US Treasury, could set interest rates to whatever level they want. In theory, they could even set rates to 0%. However, that would require the FED to essentially monopolize the US bond market and by doing so, foreign demand for US debt and US financial assets would collapse, leading to a decline in the value of the US dollar and hence an inevitable increase in inflation. This would then force the central bank’s hand to raise rates anyway, so essentially back to step one. 

The question then becomes: given the catastrophic consequences of a potential US default, why did the financial markets basically ignore the recent media frenzy surrounding the debt ceiling and why will it likely do the same next time the debt ceiling issue comes about and a threat of a US default arises? The answer is simple: there never was a threat of a US default or even a single missed interest payment. 

The US Treasury and its secretary Janet Yellen were fully aware of the potential damage a default could cause to the international financial system. They never would have allowed a missed payment to the US bondholders and there are several ways in which the Treasury can fill its coffers without Congressional approval. Some of these methods include, but are not limited to: selling Treasury assets, issuing “premium bonds”, and perhaps the most controversial, coin seigniorage, also known as “minting the coin”.

Under the “platinum coin” solution, the US Treasury mints a platinum coin with a value of $1 trillion, deposits it with the Federal Reserve, who then credits the Treasury’s account. The Treasury now has $1 trillion to use without having to issue any bonds. Voila! While this would be highly criticized and legally challenged, it would likely hold up due to the Constitution’s 14th amendment clause stating, “The validity of the public debt of the United States, authorized by law,... shall not be questioned.” The President and Treasury could use this amendment clause as justification for pretty much any “extraordinary” measure needed to keep paying interest on US bonds. 

I’m not saying the Treasury should use such measures, only that the US government was never under real threat of default and the next time this issue arises in a couple of years, don’t expect the financial markets to react as negatively as the media proclaims.