Devastating Portrait of a US Government Default

In a recent article, Simon Johnson, a former IMF chief economist and senior fellow at the Peterson Institute for International Economics, paints an revealing picture of how he envisions a debt default devastating the US economy.

The portrait is that of a series of ever more destructive dominoes toppling over — with ruined US Treasuries swiftly leading to broken money-market funds and corrupted bank balance sheets — combining to result in an unparalleled run into cash and the evisceration of corporate credit.

From Project Syndicate:

“The reason is simple: a government default would destroy the credit system as we know it. The fundamental benchmark interest rates in modern financial markets are the so-called “risk-free” rates on government bonds. Removing this pillar of the system – or creating a high degree of risk around US Treasuries – would disrupt many private contracts and all kinds of transactions.

“In addition, many people and firms hold their “rainy day money” in the form of US Treasuries. The money-market funds that are perceived to be the safest, for example, are those that hold only US government debt. If the US government defaults, however, all of them will “break the buck,” meaning that they will be unable to maintain the principal value of the money that has been placed with them.

“The result would be capital flight – but to where? Many banks would have a similar problem: a collapse in US Treasury prices (the counterpart of higher interest rates, as bond prices and interest rates move in opposite directions) would destroy their balance sheets.

“There is no company in the US that would be unaffected by a government default – and no bank or other financial institution that could provide a secure haven for savings. There would be a massive run into cash, on an order not seen since the Great Depression, with long lines of people at ATMs and teller windows withdrawing as much as possible.”

Alongside the worst outcomes, Johnson also highlights the likelihood that a default would perversely increase the relative size of government as compared to what would become the rapidly shrinking private sector of the US economy. You can read more details in the Project Syndicate post on how the nation could end up defaulting to big government.

Best,

Rocky Vega,
The Daily Reckoning