The Debt Ceiling Debacle Will Already Cause Great Financial Pain

In comedy, timing is everything — something the debt ceiling shares, only without the laughs.

A potential default, in which the U.S. would not have enough money to pay all its bills is such a potential field of submerged nuclear weapons rather than ordinary mines that no one is sure just how bad the resulting concussions would be. Widespread bankruptcies? A wave of bank insolvencies when the values of their U.S. government bond holdings were no longer certain? Seizures in global credit markets because the $24 trillion Treasurys market helps lubricate it everywhere? A loss of trust, maybe in all government debt markets, that might never be regained? Millions without government payments for Social Security, Medicare, pension funds, disability, and more? A spiraling fall of the dollar’s value and of corporate debt? Credit ratings downgrades right and left?

Whatever combination of things that might happen, there is a sense in coverage that a quick answer would put them off. And that might but isn’t the same as saying there would be no damage. There absolutely would. To understand the implications requires a different way of looking at a basic of economics, the law of supply and demand.

People usually think of supply and demand as money representing demand and goods representing supply, because that’s how the concept typically expresses itself in everyday experience.

However, to assume that money is always demand is a mistake. Money can represent supply — when money is the good that people want. If you are taking a loan out to buy a car, kitchen appliance, house, semester at college, or other purchase, you have a demand for money. The lenders who can offer it are the supply of that money.

It’s become common to see people on social media claiming that the U.S. government doesn’t actually borrow money. But it does. When the Treasury sells bonds, it is raising money to pay bills (even though many are sure the government could just print what it needed, the ultimate result of that flood of money could hyperinflation, which means a monthly inflation rate of at least 50%).

The Treasury holds regular auctions of bonds, often called Treasurys, to supplement the flow of dollars from regular receipts. Those are spread out over time because a concentrated level of demand would be an intensified period of high demand for dollars.

As economics might suggest, when demand is high, things get pricey. As the offerings for the dollars are bonds, which pay back the borrowed amount plus interest eventually, hikes in price appear as buyers of those bonds refuse to offer as much as usual. When they pay less for the bonds, the interest yields effectively go up as the face value of the bond still must be paid.

What happens when the government hasn’t settled the debt ceiling until the last minute and big bills due in June are piling up? The Treasury has to sell a lot of bonds in a short amount of time and the buyers demand more interest (as they’re taking a lot of money away from other things). As the interest goes up, the price of the bonds drops and now the government has to sell even more to get enough cash in.

It’s timing, and the implications are expensive. As Bloomberg noted last week, that could mount up to a trillion dollar need within the next few months.

U.S. bond yields aren’t something that sit in a vacuum. Many other interest rates take them into account because Treasury bond yields are the measure of what investors could get “safely,” so other investments, including all kinds of credit, being considered riskier, have to pay more.

Interest rates on all sorts of things would suddenly spike, even without the Federal Reserve making any moves to its baseline rate, because it isn’t the only force that influences where the cost of money lands.

So much demand for cash, seen as a safe investment, would suck money out of the financial system. According to the Bloomberg story, the Bank of America
BAC
has estimated that it would have the equivalent of a quarter-point interest rate jump.

Stock prices, other bonds, and people’s retirement portfolios could all take a hit. Businesses might find they can’t borrow money they need to operate and expand. There could be an increase in business bankruptcies, unemployment could rise.

In other words, even if it isn’t financial Armageddon, when political forces in Washington, D.C. finally (hopefully) come to an agreement on the debt ceiling, we’d all better be wearing seat belts.