Clinton, the WSJ, and Others on the Debt Limit and “Technical Default”

I continue to be amazed by the things some people who should know better say concerning the debt limit and a “technical default.”  For example, on Wednesday at the Peter Peterson Foundation Fiscal Summit (a Washington conference for deficit hawks), former President Bill Clinton said:  “If we defaulted on the debt once for a few days, it might not be calamitous.”  Apparently, he must have gotten an earful about this remark after the conference, because his spokesman said a few hours later that Clinton had “inadvertently misspoke,” and what he really meant to say was… (You can read about it here.)

The Wall Street Journal, of course, could not resist having some fun with this by writing an editorial – “Clinton vs. Geithner: The former President channels Druckenmiller.”  The WSJ has been pushing the idea that a “technical” default would not be so bad if it is the road to their view of fiscal sanity (large spending cuts, no tax increases), as if that could be negotiated in a few days.

Fortunately, more sensible views have been expressed.  To the extent this is a partisan issue, it is for the most part political posturing.  Most Republicans and Democrats (with some exceptions such as Emil Henry) who are familiar with financial markets and Treasury debt management operations agree that the debt limit is a terrible and usually ineffective tool to achieve political ends, whatever their views may be on spending and tax issues.

Jay Powell, a former Treasury Under Secretary for Domestic Finance in the George H.W. Bush Administration, for whom I once worked, rebutted the WSJ/Druckenmiller thesis in a letter to the editor that was published on Wednesday.  Mr. Powell notes that “most market participants, business leaders and current and former Federal Reserve and Treasury officials of both parties” oppose threatening default as a way of achieving deficit reduction.”

J.P. Morgan published a report on April 19 on why technical default would be calamitous:  “The Domino Effect of a US Treasury Technical Default.”  This report sees a technical default as leading to a run on money market mutual funds, problems in the repo market due to increased haircuts, and a decrease in foreign appetite for Treasuries.  The report also warns that a delay in passing the debt limit legislation will have adverse consequences:  “Because the tail risks from a technical default are so large, a prolonged delay in raising the debt ceiling seems likely to impact markets well before a default actually occurrs [sic].  These effects could include liquidity shortages over the late June/July period as borrowers attempt to raise additional cash and increase the tenor of their borrowings, large auction concessions especially if Treasury were to postpone an auction, increases in option volatility that cover the June/July period, and generally weaker demand for Treasury securities as uncertainty on whether the debt ceiling will be raised grows [emphasis in the original].” 

As far as market problems go, I would add to the J.P. Morgan analysis the confusion over how to calculate accrued interest for trading and repo purposes and what to do in this connection with already concluded transactions.  It would be a heavy burden to reconstruct all trades during a given 6-month coupon payment period or even to trace back ownership to the missed coupon payment date as the market continues to trade, and the Securities Industry and Financial Markets Association (“SIFMA”) would have to come up with a suggested trading convention fairly quickly in an extremely nervous market environment.