Would the US really default on its bonds?

The US debt ceiling is a recurring distraction. I expect this time to be the same as the last few, based largely on theatre and brinksmanship. However, it is worth touching on the nuances:

Not all debt breaches are equal

The world’s largest economy and global reserve currency issuer would have no problem raising extra debt. A decision by the US not to pay its debts is in no way the same as a developing country like Argentina being unable to pay its debts. 

An outright default would be devastating

Under this scenario, the world’s largest, safest asset would decide that it no longer had to honour its contracts. This would erode confidence and ignite a series of unpredictable responses, destabilising markets worldwide. The repercussions are unknowable. Where would the chain-reaction end? This scenario is highly, highly unlikely.

Alternatives to default

Given the catastrophic consequences of a default, it is more likely that the US government would implement a range of programs. This would avoid breaching the debt ceiling technically. One possible step would be furloughing federal workers, as seen in previous instances of budgetary impasses. These measures aim to temporarily reduce spending and buy time for negotiations and political resolutions.

President Biden’s trilemma

Biden faces conflicting obligations imposed by law and political constraints. He cannot change revenue (taxes) without congressional approval. Nor can he change spending. To complete the trilemma, he is also compelled not to break the debt ceiling, which is inherently tied to the previous two elements. Biden must either convince Congress to change one of these three, or defy Congress. Given the amount of time left, changing revenues and spending will not prevent a breach of the debt ceiling. One might therefore argue that if he does have to defy Congress, breaching the debt ceiling would be the way to go. A breach of the debt ceiling would certainly cause less damage to global financial systems than a default by the US on their debt.

Investment outlook

Ironically, if the US were to default on its debt in some way, longer-term government bonds would end up being a net beneficiary. In the financial shock that would follow, market participants would bet on a deeper recession, and that common sense would eventually prevail in US politics. 

Net effect: High probability of political brinksmanship, possibly resulting in a range of extraordinary measures designed to avoid default. Low probability that it is the end of the financial system as we know it. 

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