Posted by: Debby Durkee | May 15, 2011

What if the U.S. Treasury defaults?

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What if the U.S. Treasury Defaults?

Stanley Druckenmiller, the legendary investor and onetime fund manager for George Soros, sees the main financial problem for the United States as raising the debt limit without controlling spending. Druckenmiller is a billionaire in his own right. Why is he one of the few on Wall Street to say this? Why are many others claiming the sky will fall if we don’t automatically raise the debt limit? This is from James Freeman of the Wall Street Journal.

…The grave danger (Stanley Druckenmiller) sees is that politicians might give the government authority to borrow beyond the current limit of $14.3 trillion without any conditions to control spending.

One of the world’s most successful money managers…Mr. Druckenmiller is so concerned about the government’s ability to pay for its future obligations that he’s willing to accept a temporary delay in the interest payments he’s owed on his U.S. Treasury bonds—if the result is a Washington deal to restrain runaway entitlement costs.

“I think technical default would be horrible,” he says from the 24th floor of his midtown Manhattan office, “but I don’t think it’s going to be the end of the world. It’s not going to be catastrophic. What’s going to be catastrophic is if we don’t solve the real problem,” meaning Washington’s spending addiction.

Political pressure is being applied to the Republicans to automatically raise the debt limit from across the financial spectrum. A letter from giant banks on a borrowing advisory committee warned of “severe and long-lasting impact” if Congress didn’t immediately raise the debt limit. Big business borrowers warn their borrowing costs would spike. Federal Reserve Chairman Ben Bernanke warned of a market crash similar to the one after Lehman Brothers failed. And, the ever-pessimistic Treasury Secretary Timothy Geithner warned of “a catastrophic economic impact.” House Speaker John Boehner shot back at Geithner and the rest with a speech to the New York Economic Club. Here’s what Boehner had to say:

…”It’s true that allowing America to default would be irresponsible. But it would be more irresponsible to raise the debt ceiling without simultaneously taking dramatic steps to reduce spending and reform the budget process.”

So, who’s right? Druckenmiller says those issuing dire calls to raise the debt ceiling don’t understand the bond market.

“Here are your two options: piece of paper number one—let’s just call it a 10-year Treasury. So I own this piece of paper. I get an income stream obviously over 10 years . . . and one of my interest payments is going to be delayed, I don’t know, six days, eight days, 15 days, but I know I’m going to get it. There’s not a doubt in my mind that it’s not going to pay, but it’s going to be delayed. But in exchange for that, let’s suppose I know I’m going to get massive cuts in entitlements and the government is going to get their house in order so my payments seven, eight, nine, 10 years out are much more assured,” he says.

Then there’s “piece of paper number two,” he says, under a scenario in which the debt limit is quickly raised to avoid any possible disruption in payments. “I don’t have to wait six, eight, or 10 days for one of my many payments over 10 years. I get it on time. But we’re going to continue to pile up trillions of dollars of debt and I may have a Greek situation on my hands in six or seven years. Now as an owner, which piece of paper do I want to own? To me it’s a no-brainer. It’s piece of paper number one.”

Mr. Druckenmiller says that markets know the difference between a default in which a country will not repay its debts and a technical default, in which investors may have to wait a short period for a particular interest payment. Under the second scenario, he doubts that investors such as the Chinese government would sell their Treasury debt and take losses on the way out—”because I’ll guarantee you people like me will buy it immediately.”

In other words, it’s just common sense. Markets would rather bet on a country that’s getting its act together than one that continues to borrow money the country can’t pay back, which will hurt the country in the long run.

Now suppose, Mr. Druckenmiller adds, that he’s wrong. If the market implodes on day two of the technical default, Mr. Obama and Congress would be motivated to finally come to agreement. But he doesn’t expect such market chaos. “My guess is that the bond market would rally as long as it believed the ultimate outcome was going to be genuine entitlement reform—that we wouldn’t even have to find out about a meltdown because it wouldn’t happen. And I have some history on my side here.”  Snip –

“…Russia had a real default and two or three years later they had all-time low interest rates,” says Mr. Druckenmiller. In the future, he says, “People aren’t going to wonder whether 20 years ago we delayed an interest payment for six days. They’re going to wonder whether we got our house in order.” Snip –

… “I’m just flabbergasted that we’re getting all this commentary about catastrophic consequences, including from the chairman of the Federal Reserve, about this situation but none of these guys bothered to write letters or whatever about the real situation which is we’re piling up trillions of dollars of debt.”  Snip —

Druckenmiller doesn’t understand Geithner and Obama’s ruling out of entitlement reform, since that’s one cut that can be made without near-term economic impact.

One reason Mr. Druckenmiller says he spoke up in 1995 was his recognition that the first baby boomers would turn 65 in 2010, so taxpayers would soon have to start supporting a much larger population of retirees. “…We don’t have another 16 years this time. We’re there. I don’t know whether the markets give us three years or four years or five years, but we’re there. We’re not going to be having this conversation in 16 years. We’re either going to solve it or we’re going to find ourselves being Greece somewhere down the road.”

Some have argued that since investors are still willing to lend to the Treasury at very low rates, the government’s financial future can’t really be that bad. “Complete nonsense,” Mr. Druckenmiller responds. “It’s not a free market. It’s not a clean market.” The Federal Reserve is doing much of the buying of Treasury bonds lately through its “quantitative easing” (QE) program… “The market isn’t saying anything about the future. It’s saying there’s a phony buyer of $19 billion of Treasurys a week.”

… “When do you generally get action from governments? When their bond market blows up.” But that isn’t happening now, he says, because the Fed is “aiding and abetting” the politicians’ “reckless behavior.”  Snip –

…what if Mr. Obama hangs tough, Republicans cave, and there is no spending reform between now and the 2012 elections? Would Mr. Druckenmiller sell his Treasurys? “Everything else being equal, that would be a big sell factor, not a buy factor…”

…”We don’t have a choice between Paul Ryan’s plan and the current plan, because the current plan is a mirage. . . . That money is not going to be there.”

Given Mr. Druckenmiller’s track record, officials at the Fed and Treasury may not have a choice, either. They may finally have to try to explain why technical default is a crisis, but runaway spending is not.

Now, my biggest queasiness with all of this is that Obama won’t cave. Obama wants the default, and he doesn’t want to reform entitlements. He would rather be able to go into the 2012 election blaming Republicans for a new financial crisis rather than to do what’s right for the country in the long run. We must remember who we’re dealing with here. We aren’t dealing with a patriotic American president who wants what’s best for the country he loves. How better to “fundamentally transform” the country than to let it collapse. We’re dealing with someone who sees himself as Hugo Chavez, who only wants what’s best for him, and if he has to take the country down to do it, then that’s the price he’s willing to pay. I hope I’m wrong. Maybe there are still some Democrats out there who can convince him differently, but I’m not sure many of them get it. And, I’m not so sure many of them see the country any differently from the way their president does.  Read it all here:

http://online.wsj.com/article/SB10001424052748703864204576317612323790964.html?mod=WSJ_Opinion_LEADTop

One more thing that seems tangentially relevant here is the refusal of the Democrats to put up a budget of their own. This is already all about the 2012 election. They don’t want the country to see how high they plan to raise our taxes if they get back in control of the purse strings. This is from John Hinderaker of Powerline blog.

…(Friday), the Republicans on the Senate Budget Committee commented on the Democrats’ paralysis:

With the statutory committee deadline having been missed by six weeks, and with 744 days gone by since the Democrat-led Senate passed a budget, it was reported that this week Senate Democrats would finally produce a budget and hold a markup.  But no budget was produced and the markup was delayed yet again. … [Ranking member Jeff] Sessions summarized the “big problem” facing Democrat leaders…: “they cannot bring forth a budget their members support that the American people will support, and they understand that, they know that, and they’ve got a big problem.”

Apparently, Senate Budget Committee Chairman (and outgoing Democratic senator) Kent Conrad has been stymied by his own committee member, Socialist Bernie Sanders.

…The Hill reported that Senator Conrad shifted the Senate Democrat budget further to the left as a result, coupling every dollar of savings with a dollar in higher taxes – even as the President asserted his so-called framework would achieve three dollars in savings for every one dollar in cuts, albeit a claim that is not borne out by the numbers. …

Following these revelations, [Congressional Quarterly] published a report indicating that the Senate Democrat Budget had even fewer savings than advertised – cutting only $1.5 trillion over the course of 10 years.

As Hinderaker has noted, if the Democrats can’t come up with a suitable budget during a time of crisis, how can we count on them for much of anything serious?

…the Democrats apparently are incapable of coming up with a plan to dig out of the hole their profligate spending has created. What could be clearer evidence of the intellectual bankruptcy of liberalism?

And that, ladies and gentlemen, is why I fear an Obama punt on tackling entitlements or any budget reform in exchange for raising the debt ceiling. It goes against their leftist desires to want more, more, more even if there’s nothing left to give. Look at Wisconsin. Look at California. Look at union demands in the face of crippling the company or the state they work for. They are parasites, and they’ll continue to suck the lifeblood out of the country until there’s nothing left. Will any sane Democrat who loves their country please stand up? We are living in Atlas Shrugged.

Read it all here: http://www.powerlineblog.com/archives/2011/05/029035.php

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