Default, Which No One Fears

The Washington administration is dreading Aug. 2. It was engulfed by fear after finding out that this week the federal government’s debt reached the statutory ceiling of $14.3 trillion. America owes this astronomical sum urbi et orbi — to the city and to the world.

The U.S. Treasury gave Congress an Aug. 2 deadline for raising the debt ceiling. Now the administration will be forced to raise funds of $125 billion per month for the country to keep functioning. The U.S. Treasury believes that it can avoid a crisis, at least until August. It’s has an impressive “stash” to accomplish this: $100 billion in cash on deposit at the Fed, $232 billion dollars saved for a rainy day, 261.5 troy ounces of gold, valued at $402 billion, oil valued at $81 billion, a loan portfolio of $923 billion and investments in General Motors, AIG and banks, which were made during the recent recession.

It looks impressive. But in fact, only the first two “stashes” may be used. The default will stop all others. U.S. Treasury Secretary Timothy Geithner recently warned Congress that when these resources are depleted, the government would be forced to default. Geithner warned that the government would not be able to pay soldiers’ salaries, unemployment benefits, health insurance and tax refunds.

This will have catastrophic consequences. Treasury debt would become too risky for investors and would require a sharp increase in interest rates. That’s the view among many experts, including Federal Reserve Chairman Ben Bernanke. It should be noted that in the second half of this year alone, the Treasury intends to borrow $405 billion. Even if interest rates increase by just one percent, it would mean an additional $405 million dollar increase in debt per year. Of course, one option is not to pay. But America’s default is equivalent to a global crisis. According to Treasury Assistant Secretary for Financial Markets Mary Miller, “What participant in the market would want to buy our debt as we are defaulting on other obligations? I think the markets would be completely spooked.”

But here’s what’s interesting: The investors aren’t panicking yet. They are relying on past experience, when, on the verge of default, Congress capitulated and raised the federal debt ceiling. Many investors consider the current hysteria in Washington to be a theatrical performance. A few words about the past experience: In 1995-1996, the investors demanded a half percent increase in interest rates. In 2003-2004, they asked for an even smaller increase, and in 2005-2006, investors did not demand a risk premium (according to the research done by Pu Liu, a financial expert from the University of Arkansas).

Why?

Default. Collapse. Crisis. Catastrophe. Scary words. They hang over the U.S. like the sword of Damocles. But this sword is sheathed. No one dares to unsheathe it — neither China nor India, neither the E.U. nor Russia. This financial sword of Damocles is like a hydrogen bomb. Using it is like committing suicide. A financial and economic catastrophe in America would mean a worldwide catastrophe. This is well understood by the United States’ main rivals and bitter enemies. Consequently, their “Tango of Death” with Washington comes to the brink and stops there. In this dance, the partners are blackmailing each other. Some threaten to throw America in the chasm called history’s trashcan. The other — United States retorts that if this happens it will pull everyone else with it.

Blackmail also works in Washington’s domestic politics. For example, in early 1996, Clinton’s administration asked Congress to raise the debt ceiling. Congress refused. Then, the president threatened to stop paying Social Security. Congressmen capitulated. The debt ceiling was raised. And since then, it keeps rising!

You might say, “Well, just let it rise.” However, let’s remember the comparison with the financial sword of Damocles and a hydrogen bomb. While nuclear weapons exist, so does a threat that they’ll be used. But there’s a reduction in nuclear weapons; a whole system of treaties was created restricting them, and an international organization controls their distribution. With respect to the financial sword of Damocles, such powerful checks don’t exist, even though the stakes are also oh so high.