What would default look like?

As you may know, I do not wish to be a sensationalist on this topic.  As Felix Salmon has pointed out, the recent spike in short-term T-Bill prices still isn’t that big a deal.  So please consider this question as a (mostly) academic exercise.  And by the way, if/when they pass a short-term debt limit extension, you can simply update the specific dates given in this post accordingly, maybe you will need to add six weeks or so.

Anyway, here is one (unlikely) scenario.  As the evening of October 16th approaches, John Boehner is preparing to invoke the Hastert Rule when a car accident intervenes and he is temporarily out of commission.  Coordination collapses and some Republicans believe that on the 17th debt payments can continue while some other federal obligations are violated instead.  A combination of insufficient payment prioritization (for bizarre technical reasons) and angry Social Security voters, who irrationally fear missing their deposits, means that some payments are in fact missed on Treasury securities.  Some GOP representatives see this as a new chance to blame the Obama administration, and no one can agree quickly exactly how to reorder the payments, and so the mess isn’t cleared up immediately.

But before this accident gets well underway, word leaks out through various “insider trading in conjunction with investment banks Capitol Hill staff members” that not all is well.  Interest rates skyrocket and there are numerous collateral calls from clearinghouses and thus a squeeze on Treasuries.  Everyone is scrambling after Treasuries and suddenly T-Bill liquidity is quite scarce.  (Here is one FT post on collateral crunch.)  The next morning retail runs on money market funds commence and most redemptions cannot be made (another FT post here).  Those funds are shuttered and new commercial paper issues are put on hold.

By mid-morning of the 17th the payments system has shut down entirely.  The Fed tries everything possible, but even with a flood of monetary liquidity, T-Bills are “not what they used to be” and no flow of reserves can make up for this.  The monetary authority cannot become the fiscal authority in the span of an hour or a day, especially when it doesn’t have a fully credible fiscal authority behind it.  The payments system remains gridlocked.  Elsewhere, the Italian 10-year rate shoots over eleven percent, so the ECB has to invoke Outright Monetary Transactions, but the Germans get nervous and don’t go whole hog with this program.  A lot of European credit markets shut down too.  A major clearinghouse is nationalized.

Obama prepares the Super-Premium Treasury issue, and a few days later this happens.  By that time Boehner is again running the Republican Party and enough of the payments mess is sorted out for money markets to function again, albeit at slow speed, although some previously illiquid major financial institutions are now insolvent and they are nationalized.  No one knows which of the others are actually solvent, due to the interest rate spike, and so there is a general and longer-lasting credit collapse.

A full sorting out of the payments mess takes months.  In the meantime gdp has shed five or ten percent and borrowing costs are permanently higher.  Credit stays slow and the United States enters another major recession.  Scott Sumner issues a call for higher nominal gdp.

Fortunately, none of that is very likely to happen (except the part about Scott).

Addendum: By the way, we used to read that an attack of the bond market vigilantes would be good for the economy, but it seems this is no longer the case when the vigilantes are led by Republicans.  Hint: an attack of the bond market vigilantes is not good for the economy.


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