- The August 2nd US Debt Default

The next economic collapse may turn out to be completely predictable. On August 2nd, 2011, the US Treasury runs out of tricks. That’s the day that current expenditures can no longer be maintained unless the debt ceiling has been increased. That’s the day, that absent a deal between the Republicans and the Democrats in congress, the US will default. But there is a legitimate question about what that will look like.

The thing is, from fifty thousand feet a default looks like a very clear black and white line. But as you grow close to it, all of a sudden a wide expanse of gray emerges. Clearly non-payment of interest or principle would be a default. But what about late payment? Or what if certain bond holders (the Fed) were to voluntarily forego their interest and principle to allow all others to be paid? What about a negotiated deal with other investors? Would that constitute a default?

The problem is that finance is fairly clear on where the lines are and what they mean, but the law is not. And in the end all these financial agreements are all built upon the law. The law is a vague thing subject to endless re-determination, and definition. At the risk of sounding Clintonesque, it can mean whatever you want it to mean, or in this specific case, whatever you absolutely need it to mean. So if you don’t want to call it a default, then … don’t… and if your reasons sound believable, then maybe it isn’t.

What’s more, even when August 2nd arrives and there is no more cash, there may be a rabbit or two left in Timothy Geithner’s hat. There are laws about this sort of thing that I’m not knowledgeable about (maybe no one is). But if Geithner were running a bank, then he could go ‘off balance sheet’. He could issue a Swap (pay float in the future receive fixed today) in the amount he needs to keep things going. This might even be a good idea politically if on August 2, no deal has been made but it looks like one is imminent.

Who would take the other side of a swap like that? Honestly I don’t even know if it would be legal to do so. But assuming it was, he would need to find an institution large enough to supply him the needed amount of cash that also has something big to lose if the US defaults on it’s commitments. A big bank say, or maybe an insurance company that relies on the US as a guarantor. In other words, instead of the government bailing out the big Wall Street banks, the banks, (using cheap money supplied by at the Fed window and supplanted with a relaxation of the reserve reqs.) would bail out the government.

Right now they’re rioting in Greece where the cumulative debt is roughly $44,000 per person. In America at present, it’s $45,000 per person. But in economics size does matter. If Greece goes it will hurt 11 million Greeks directly and all Europeans indirectly. But if the US goes, it will hurt every man, woman and child on the planet. We are the world’s anchor. We’re the thing that makes the rest of it possible. You can amputate a leg or an arm and still live. But you can’t amputate a head.

So my bet is that if the Republicans really do force the issue and Obama won’t back down on his plan for new taxes on the most productive citizens, then they’ll fudge the law around in some way that gives the Treasury enough breathing room to prevent what the market interprets as a classic ‘default’. There will be talking heads who complain about it. And many people in the industry who are talking up their books will still describe it as a default. But so long as the markets don’t treat it like a default, then everything will be fine.

The law is where the wiggle room is. And in the end I think we’ll wiggle as much as we have to. One of the central theses of economics is: "Things that can’t happen, won’t." And I know most people in the markets view a US default as something that can’t happen. Not without consequences too dire to imagine. what's a little Clintonesque fudging of the meaning of the law, when measured against that?



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For the record, I think the Republicans have the right view of this issue politically. This is Obama's economy. He's the President. He's the one demanding vast new spending programs, green energy subsidies, and union giveaways. If the US is seen as having defaulted on it's debt, whatever the short term consequences, history will remember Barak H. Obama, lord of unprecedented deficit spending, as being the one who is ultimately responsible for it. And what grief doesn't fall directly onto Obama's head, will be blamed on Harry Reid and congressional democrats, who haven't come up with a budget in nearly 2 years.

Whether they mean it or not, the Republicans are seen as being the grown ups here. Obama and his ilk are at best, seen as the amateurs from the faculty lounge, theorizing and playing silly self congratulatory games with the future while other people pay the price. At their worst, the SEIU and others are seen as the looters of a nation. They fit the bill of the villains in an Ayn Rand novel, blindly robbing all they can and assuming that the parasite is entitled to feed on it's host.

If we are seen as having defaulted on our debt, I believe it will be the end of the Democrat party for decades.