Why the US just might cross the line of 'extreme idiocy'

"The United States government is not going to default, ever."
By · 9 Oct 2013
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9 Oct 2013
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"The United States government is not going to default, ever."

That's what Vincent Reinhart, former head of the Federal Reserve's monetary division and now managing director of Morgan Stanley, said late last week.

"As political theatre," he said, "the debt ceiling is not a useful threat, because politicians are basically threatening to shoot themselves, as they will rightly shoulder the blame for the serious global economic consequences of a default."

Reinhart's view has become conventional wisdom on Wall Street when it comes to whether the country will hit the debt ceiling limit on October 17. Warren Buffett put it this way: "We'll go right up to the point of extreme idiocy, but we won't cross it."

Nobody believes the country will actually exceed the debt limit, which is exactly why it might. Oddly enough, despite all the predictions of panic, the sharemarket was down only marginally over the past couple of sessions.

Here's the perversity of Wall Street's psychology: The more Wall Street is convinced that Washington will act rationally and raise the debt ceiling, most likely at the 11th hour, the less pressure there will be on politicians to reach an agreement. That will make it more likely a deal isn't reached.

John Podesta, a former chief of staff for President Bill Clinton, said that while only weeks ago he believed it was almost impossible that Congress wouldn't reach a deal, he now wonders whether it will be reached in time.

What happens when the government exceeds the debt limit? It is often forgotten, but it actually did default once, in 1979 - by accident.

Here's a history lesson from Donald Marron of the Tax Policy Centre. He wrote on his blog in 2011 - the last time this game of chicken was taking place - that Congress raised the debt ceiling at the 11th hour in 1979 but the government "defaulted because Treasury's back office was on the fritz". He explained that the government ultimately paid the debt back in full.

So, what happened to interest rates?

"T-bill rates rose almost 0.6 percentage points. There's no indication this increase reversed in the days that followed."

That may sound like a lot - and it is - but let's put that in context: "T-bill rates hover near zero compared to the 9-10 per cent range of the late 1970s; that means a temporary delay in payments would be less costly for creditors."

Of course, for the past several weeks we have heard ad nauseam how imperative it is for Congress to raise the debt ceiling or put at risk the creditworthiness of the US. Even approaching the deadline without a resolution was supposed to send the market into a panic and interest rates skyrocketing.

And yet here we are, about a week before the deadline, and the market hasn't cratered despite remarks over the weekend by House Speaker John Boehner, who indicated, for the first time, that he planned to use the debt ceiling as a negotiating chip in seeking concessions from President Barack Obama, who has steadfastly refused to negotiate.

Almost bizarrely, the market's reaction - or lack of one in this case - may actually contribute to an outcome everyone has been railing against.

The ruinous potential for a default has had Wall Street leaders screaming from the rooftops: "Whatever circumstances and disagreements got us to this current unhappy juncture, there is no way that our government leaders can allow the full faith and credit of the United States of America to be jeopardised. This is an issue that affects every single citizen," Morgan Stanley chief executive James Gorman wrote in an email to his employees, urging them to contact their representatives in Washington.

For some market participants, the prospect of reaching the debt limit isn't worrisome, not because they don't think a deal will be reached but because they believe that the October 17 deadline is either fake - they speculate that Treasury Secretary Jacob Lew has built in some wriggle room to force a decision - or that the government will ultimately be able to prioritise certain payments over others so that it can continue to pay its debts and Social Security payments.

A year ago, Stanley Druckenmiller, the hedge fund manager, told The Wall Street Journal: "I think technical default would be horrible, but I don't think it's going to be the end of the world. It's not going to be catastrophic."
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