Technical Default? Don't Even Think About It

This past week, differing assessments of the effect of a “technical default” on United States sovereign debt widened the debt ceiling split among politicians on Capitol Hill.

The first view we can, for shorthand purposes, call the “Toomey Plan,” after Pennsylvania Sen. Pat Toomey, who first publicly pushed it. That view is quite straightforward: enough cash comes into the Treasury each month that America can pay its debt obligations with ease.  Yes, that means some other functions of government may suffer or even end, but that short-term pain is worth it if a real long-term debt package can emerge from the chaos.

This view, approximately, lines up with some Wall Street investors who believe that even a technical default that causes short-term disruption among global financial markets can be tolerated. Again, yes we have short-term pain, but over the long run, the United States will be in a better financial position than it is likely to be in if we fail to have a long-term, credible debt reduction plan.

Some Members of Congress invoke the name of Stanley Druckenmiller, a very successful Wall Street denizen, who proposed this analysis earlier this year and had urged it on Congress during the 1995-6 debt ceiling showdown.  House Speaker John Boehner had a list of 150 economists who urged a large, credible debt stabilization plan as a pre-condition for passage of the increase in the debt ceiling and he took that list with him to the White House when he met with President Obama earlier this month.

The other view we can term the “Establishment Plan.”  Supporters of this analysis contend that even a short-term technical default would cause sufficient chaos in global financial markets such that the United States would suffer a grievous economic and financial wound.  Either a true default—in which the United States fails to pay on time and in full its outstanding sovereign debt obligations—or a form of the Toomey Plan leading to large-scale government agency shutdowns would cause serious harm. In this group are rating agencies like Standard and Poor’s, J.P. Morgan, Fitch, and Moody’s.

Not surprisingly, proponents of the Establishment Plan are members of “The Establishment.”  Think of the Department of Treasury, Wall Street advisors to the Treasury, CEOs and presidents of global and regional financial institutions, a large number of economists from academia and think tanks, as well as former members of the Washington, D.C., opinion elite and most mainstream media, including The Economist, Washington Post, New York Times, and similar voices.

Prominent among “The Establishment” stands Treasury Secretary Tim Geithner.  Geithner, of course, speaks with substantial authority for a number of reasons.  It is his department that manages the public debt.  It is his department that has to go continuously to global credit markets to sell and roll over our debt.  And, it is his department that publishes the daily income statement of the United States. Geithner knows America’s debt position and funding needs better than any other single senior official in the country.   Geithner also knows markets and market-makers very well, since he used to be the president of the New York Federal Reserve, which daily reviews activity in Wall Street.

James Carville, political strategist, said, “If I come back in another life, I want to come back as a God d***** bond trader.”  That was his way of highlighting the power that credit markets have over large sovereign debtors who follow sloppy fiscal policies (think of Greece as a modern example). And, it reflected the fear of the Clinton Administration and then-Treasury Secretary Bob Rubin when it came to suggestions to challenge the wisdom and power of markets.

So, who’s right?

Since it is a matter of first impression—after all, modern America has never defaulted to any significant degree on its debt—both sides have begun to argue and assert scenarios.  No one can “prove” either view right.

But a look at modern financial engineering gives us real clues to the likely answer.

Privately ask a Wall Street investor running money for others what would happen if the Toomey Plan prevailed.  Remember, in that plan, all United States sovereign debtors would be paid in full and on time.  Little money would be left to fund many other government functions, with the resulting overnight shuttering of entire departments and immediate layoffs of hundreds of thousands of government employees.

The consensus response is “chaos.”

Now if an active credit market maker tells you that chaos would occur if some scenario became a reality, the wise should listen.  This bond trader isn’t theoretical.  He or she is telling you what they would do in the event of a Toomey Plan—run for the doors.

The real question for Members of Congress, then, isn’t whether they “believe” Toomey or the Establishment view is right.  The real question is simply, “Which way do you want to bet your entire career and the economy of the country on?”  Even most of the new Members are beginning to enjoy the privileges of power, privileges that will disappear if their actions tank the economy and financial markets.

So, the prudent person should look askance at the Druckenmiller/Toomey suggestion.  If a majority of market participants and folks who have been out selling our debt to markets for decades say that the Toomey approach would severely injure America’s economy, that’s the way I am going to bet.

The long-run argument—the Toomey Plan that has at least a dozen supporters in the Senate--sounds so noble, so almost moral, so “gutsy,” that some may go that way. Testosterone will do that sometimes.

Such would-be warriors  would be well served to remember John Maynard Keynes:  “In the long run, we are all dead.”

Or if they want a more recent example, here’s Warren Buffet on the dangers of a form of modern financial engineering called derivatives:  “Derivatives are financial weapons of mass destruction.”

Just for the record, even a technical default on payment of American sovereign debt would shatter parts of the derivatives markets, endanger global financial markets, and have other “non-trivial” consequences.  Or, at least, that’s what folks who make a living in that market say.

The Toomey Plan sounds a little bit like a military advisor telling his superiors, “Well, you know we could always try a small tactical nuclear weapon to see if the doom-sayers are right.”