People seem to be despondent over the lack of political compromise on the federal debt limit. I do not share that concern. Incidentally, neither does the bond market.
To be clear, the United States is both financially and morally required to meet its obligations. Not doing so would expose an astounding lack of political leadership that would undermine the credibility of the country. But the disaster scenario -- default on US debt -- is still unlikely. First, because a compromise that involves deficit reduction along with a debt ceiling increase is still the most likely outcome, as it is the most sensible, even for our politicians with their polarizing agendas.
And second, because the US government collects much more in taxes than the amount necessary to service the debt. So even in the unlikely event that the debt limit is not increased, the coupons on US treasuries will still be paid and Treasury will prioritize other government expenditures, even if it has to shut down non essential government services.
More importantly, the debt levels are not the main concern. The real threat to the country's long term financial health is the ongoing deficit. US revenues were about $2.2 trillion last year. Expenditures were $3.5 trillion. Interest payments were only about 6% of that. Entitlements -- Medicare, Social Security and unemployment insurance -- accounted for roughly 58% of total expenditures. And defense was another 20% (it seems strange that any country would dare to have 150 military bases around the world and be involved in three wars while running a deficit of over $1 trillion a year, but, that is a whole other topic).
Such perennial deficits are obviously untenable. It is the one issue we simply must deal with, and it is certainly not impossible. If we limit government spending to the level it was in 2007, not exactly the age of austerity, we will have a balanced budget within three years. If we than keep it at that level for ten years, we will also substantially reduce our debt levels. This will return the country to very solid financial footing.
If the mere talk of the debt ceiling will force a serious national conversation about priorities that would finally put the country's fiscal house in order, I would argue such outcome is a net positive. In any event, for an owner of a Treasury debt instrument, it would be better to miss out on a few months' worth of payments and emerge with a fiscally responsible country that is a better lending risk, rather than keep collecting payments in a deteriorating currency, and from a country hobbling down the path to fiscal ruin.
For that reason I also don't subscribe to the notion that default would cause interest rates to spike. There are enough savvy investors out there that understand the long term benefits that emanate from forced fiscal discipline, and they would snap up treasuries on any weakness, knowing they are effectively guaranteed to collect the principal plus all back pay.
This point is made more relevant if you recall that traditional default (suspending payments on debt) is not the only form of avoiding payment. Inflation is also effectively default. It is more stealth and vile, but gets a similar end result.
In fact the U.S. has continuously engaged in devaluing the currency to the detriment of its debt holders. Right now, Treasury is making the payments on time, but those payments are made in a constantly weakening currency. And consequently, the price of anything denominated in dollars is going higher.
It isn't demand from emerging economies that is driving the prices of wheat, cotton, oil or Swiss Francs higher. It is the decline in the value of the dollar. In fact, over the past four years, neither wheat nor oil prices are up if measured in Yen (they are each up about 50% vs. the US Dollar), and have actually gone down vs. gold.
In light of that, I don't see the point of increasing the debt ceiling if it simply perpetuates our incorrigible spending habits. If this faux crisis forces political will to confront our structural fiscal issues and finally behave rationally, then I would consider it very good news.