Debt Ceiling Gives Investors Master Class in Complacency
The Republicans in Congress have backed down and agreed to suspend the debt ceiling, so the U.S. is, at least for now, not likely to default on its obligations. But the threat leaves a question, not least because it is merely delayed to December: Were investors overly complacent, or were they right to believe nothing serious would happen?
Investors clearly expected Republicans to cave in, with short-term Treasury bill prices showing that even if a default happened, any problems would be short lived. Markets, however, are terrible at assessing high-impact events that are very unlikely to happen. This can create sudden huge shifts in prices. The result is a form of permanent complacency, where unlikely but really bad events are ignored until they are so close they demand immediate attention.
Treasury bills this month started to price in the danger that there would be a temporary problem. The yield on the T-bill due to mature on Oct. 26, shortly after the debt ceiling would most likely be breached, jumped from 0.05% at the start of the month to 0.15% by Tuesday. It collapsed back to 0.08% after Senate Minority Leader Mitch McConnell offered a two-month suspension of the debt ceiling. The government was paying more than highly rated companies for some short-term borrowing.
Officials talked up the disaster scenarios in an effort to bring around Senate Republicans, with Treasury Secretary Janet Yellen saying a default would “likely precipitate a historic financial crisis.”
Investors never thought any problems would last. Yields on bills maturing in December had fallen, rather than risen. Just as when the Republicans threatened to take the country over the brink in 2011, the best place to hide from a U.S. default was…Treasurys. U.S. assets are absolutely central to the global financial system, and no one believes that senators will put that at risk for more than a few days.
Worse, if the U.S. defaulted in full, and stayed in default, and the Federal Reserve didn’t do anything about it, it would trash the value of pretty much everything. Defaults would ripple across companies, banks, other governments and individuals, and the world economy would be crushed. It isn’t clear any assets would provide a shelter, short of well-stocked bunkers.
It was entirely reasonable for investors to think that such a default almost certainly wouldn’t happen. The last time the Republicans decided that the debt ceiling mattered, during the Obama administration, they twice threatened default before retreating. The markets took it badly in 2011, and the U.S. lost its pristine credit rating. By 2013, investors had decided that the politicians were all bluster, and pretty much ignored that year’s threats.
On top of that, there are several ways the government could avoid or mitigate a default, including scrapping the filibuster, claiming Congress is in breach of the constitution, minting a $1 trillion coin or persuading the Fed to buy defaulted bills and bonds.
It is also reasonable to think that a minor default doesn’t much matter. The U.S. has failed to meet its obligations at least three times in its history, contrary to Ms. Yellen’s claim that it has always paid its bills on time.
These repeated failures to pay—after the war of 1812, in 1933 on gold owed to Panama and in 1979 due to what The Wall Street Journal reported at the time was an “embarrassing back office crunch”—didn’t interfere with the U.S.’s ability to borrow more, or even obviously push up the cost. This isn’t surprising when you look at the ability of even the dodgiest emerging-market governments to take on new loans shortly after defaulting. Investors focus on the future and tend to think each default is a one-off, even for serial defaulters such as Argentina or Greece.
Which leaves us with the question of whether the market was complacent this time around, and so might still be complacent about a default in December, especially one that lasts for more than a few days. History is replete with examples of catastrophic defaults, although cases where countries renounce their debt entirely typically come after a revolution, not a partisan standoff.
The biggest example of market complacency in the past few decades was just last year, when investors ignored the spread of Covid-19 for weeks after human-to-human transmission was confirmed. The crash started only after Italy locked down parts of the country. Complacency can apply even to events that have been widely predicted, such as the now-likely default by China Evergrande Group, or the bursting of the dot-com bubble. Bad stuff will probably happen one day, many investors reason, but I am smart enough to get out in time. Not everyone can get out at once, of course.
In all these past cases, policy makers and the wider population were as complacent as the markets. If something is too awful to contemplate, only the deeply bearish will want to consider it during the good times.
This is both the hope and the fear about a U.S. default: It is too terrible for the Republicans to consider or the White House to allow. It is also so awful that investors haven’t prepared, massively magnifying the market impact should it ever, finally, come to pass.