US debt default and threat of “substantial market stress”

Can the US avoid a debt default? Certainly, the situation is severe, with the US Secretary of the Treasury Janet Yellen warning of “substantial financial market stress” as the political drama over the US debt ceiling continues.

London Business Schools’ Professor Richard Portes airs his characteristically trenchant views on the subject on a recent CNBC interview (CNBC, 22nd May 2023), commenting on the situation as one where one “[Should] not negotiate with crazies”.

Republican House Speaker Kevin McCarthy, who has most recently stated that with budget approval yet to be reached, and with the Republicans wielding power in the House of Representatives, the House is “still far apart” on a number of issues as the crucial June 1 deadline approaches.
With the Republicans in power in the House, they are currently trying to use the debt ceiling to force cuts to public spending, creating an impasse with US President Joe Biden.

“I think that negotiation is not the right way to go,” adds Professor Portes. “Some commentators think that it isn’t a big problem but I think that it is. The 14th Amendment says that the ‘full faith in the credit of the US government should not be impugned’. That is sufficient according to a number of constitutional lawyers, unfortunately the Secretary of the Treasury has said that she really doesn’t want to go that way but it’s not clear what other way she wants to go. Minting a platinum coin? Yellen has ruled that out I think. Issuing high premium treasury bonds that would sell for much more than an ordinary treasury bond? It is a thought but not a very good one. I don’t see a clear way out of this.”

Professor Portes lamented the dynamics of the situation, observing that a “complicated package to which one or another person is always going to object will not ever work”. “However, if Biden and Yellen can make it work, then good for them, but I don’t see how it can happen with a clear way out of this. This is a serious business; the consequences of this are potentially very severe. The notion that some Republicans say, ‘Oh, it’s not a big deal’ [does not] capture the seriousness of the situation. In the past, common sense has prevailed. Today, it’s not clear that common sense will prevail, [certainly not with] Donald Trump egging on the crazies, and the crazies set in their ways.”

What are the consequences if a deal is not struck?

“It is almost too painful to talk through the consequences,” says Portes, adding, “The first impacts would on the markets which would go completely crazy. The US Treasury is the backbone of not merely of the US domestic markets, but also the international markets. The spill over [from a debt default] into domestic and international markets would be immediate. One big consequence would be the depreciation of the US dollar, a fall overall in markets and a downgrading of the US dollar which would then force some institutions that can’t hold bonds below top grade to sell them, further pushing down the price of treasuries. Some treasuries might go up because some investors will have to move into safe assets but short Treasuries would be presented with a very bad scene. The overall position of the dollar in the economy would be weakened.”

Professor Portes notes that there is a continual level of debate about the decline of the dollar and the consequences of sanctions. “I don’t think that this type of discussion has much in it right now, but if the US were to stop payment with Treasuries coming due, a default could shatter the $24 trillion market for Treasury debt, and cause financial markets to freeze up and could ignite an international crisis.”

President Joe Biden is pushing to raise the national borrowing limit above its current rate of $31.4trn (£25.3trn), but Republicans are resisting.

Without a deal, the US faces the possibility of defaulting on government debt payments as soon as next week.