America’s default won’t trigger market chaos — and that’s the problem

The rhetoric around raising the U.S. debt ceiling continues to soar. Janet YellenJanet Louise YellenWhite House seeks to flip debate on agenda price tag Alabama clears plan to use COVID-19 relief funds to build prisons The Hill’s Morning Report – Presented by Alibaba – Democrats still at odds over Biden agenda MORE, the most understated Treasury Secretary in memory, told Congress that a failure to act “would be a self-inflicted wound of enormous proportions.” Federal Reserve Chair Jerome Powell, who rarely resorts to hyperbole, has warned of “severe damage,” adding the Fed could not protect the economy in the event of a default.

They are surely right that this Congress should raise the debt limit so that the United States can legally borrow the money its predecessors committed to spend. They are also right that a default by the world’s largest borrower in the reserve currency of the global financial system is a step into the unknown.

But it’s not obvious that congressional failure to act will trigger chaos on Oct. 18, when Yellen now predicts the limit will hit. More likely is a brief period of volatility until Congress does act. More damaging will be the lessons drawn by partisans on both sides who conclude they can breeze through the limit next time — and the time after that. A pattern of such behavior will deal extensive disruption to America’s financial infrastructure and undermine economic growth prospects.

Why is disaster unlikely now?

First, this default would not fall into the traditional sovereign debt categories. It’s not that the United States “can’t pay” its debts, since it can always print dollars. It’s not even that it “won’t pay,” because there is no claim in Congress that the debts are illegitimate or what lawyers call “odious.” Everyone holding America’s debt will get their money.

Second, more likely than not, the Treasury will continue to service the debts and roll over those coming due, while delaying payments on salaries, contracts and benefits, including Social Security and Medicare. That, at least, was the plan when the last debt limit showdown loomed in 2011.

Third, one of the oldest rules of investing is that if you sell something, you need to buy something. Anyone who feels obliged to sell U.S. Treasuries must either choose to hold cash, gold or buy some other government’s securities. Some investors will hold their noses and buy European or Japanese debt, but their negative interest rates make even a technically defaulted U.S. obligation more attractive for now. Other alternative markets are either too small or too risky to absorb much Treasury outflow.

For all the talk around the “full faith and credit” of the United States government, there is actually some history with default. In 1933, efforts to reflate the economy caused sharp dollar devaluation and President Franklin Roosevelt backed legislation to abrogate standard clauses in debt contracts that allowed the lender to…