When will US debt be downgraded? By how much?

This whole notion of a legislated debt ceiling- (unique to the U.S.)- was originally instituted with the U.S. entry into WW1, as a means of maintaining Congressional control over Executive war-making proclivities. A small historical irony.

“What’s your evidence that the second part of this is true?”

The best evidence is that without a tax increase the US Govt will not be able to pay all the things it has already promised to pay. Social Security is a small part of it, Medicare a much larger part of it.

They can of course change the amounts they’ve promised to pay: but these are “cuts”.

It’s not “the govt should be larger” or even “smaller”. It’s that spending committments made years ago cannot be funded by the current tax regime. Accounting really, rather than politics or economics. Either taxes rise or future spending is cut.

At this point, loud alarm bells have started ringing for the big ratings agencies, Standard&Poors and Moodys. They will have to decide, well before August, whether to downgrade US government debt and if so by how much.

I can’t imagine how the ratings agencies could expect to retain credibility if they do not downgrade U.S. debt. The relevant question is whether they are independent organs at all, rather than about the intrinsic credit-worthiness of U.S. debt: the question of downgrade is about the ratings agencies themselves. Being willing to open the political can of worms and downgrade American debt is the ultimate test of credibility and independence there is, and the one who does it first will lead the pack. The way to pose the question isn’t “how should Treasuries be rated given their unique nature,” but rather “if the ratings agencies are sticking their fingers in their ears and going lalalala about Treasuries, of all things, what on earth on they good for?”

The ratings agencies are US firms operating in a US political context, and their actions will be governed by a mixture of concerns, starting with self-preservation, but also including a desire to influence US policy in a way favorable to bondholders as a group.

I don’t see how “US firms operating in a US political context” is necessarily intrinsic to globally operative ratings firms.

I can’t imagine how the ratings agencies could expect to retain credibility if they do not downgrade U.S. debt.

Two questions:
Do they have credibility?
And,
Is there a more secure asset than US government debt? – I mean an asset or a collection of assets comparable in size / capacity.
And if the answer is “No” a third question:
Where and when will the liquidation / closing-down sale start, and what will the sellers be looking for in return for their assets? Not dollars presumably.

Barry Eichengreen has had smart and relevant things to say about the dollar.
http://www.project-syndicate.org/commentary/eichengreen31/
This follows him saying smart and relevant things about the euro. Nobel-level smart, I’d say.

Of course Krugman got it for his work on trade, not on the NYT opinion page. But the Nobel committees seem to be considering topical relevance as a criterion these days.

I assume it’s finite, which would not be the case under plausible scenarios with no new revenue and maintenance of current discretionary expenditure relative to national income.

As it happens, this statement is incorrect.

Call the primary deficit (i.e. net of interest payments) as a share of GDP d. Call the debt-GDP ratio b.g is the growth rate of GDP and i is the interest rate on government debt, net of tax. (g and i can both be nominal, or both real.) Then in the long run, b = d/(g-i). In other words, if the growth rate of GDP exceeds the after-tax interest rate on government debt, then there is no value of the primary deficit for which the debt-GDP ratio converges to a finite level.

Figuring out the relevant tax rate to subtract from the measured interest rte is a bit tricky, but in this case it doesn’t matter. Over the long run for the US, g – i averages around 0.6 Outside of recessions, it has not been negative for 20 years. So the condition that the growth rate of GDP exceeds the after-tax interest rate is clearly satisfied for the US.

So your assertion is wrong as a simple matter of math. It really surprises me how many people make this mistake.

And even if you want to claim that the historical relationship between g and i is likely to be be reversed in the future, the statement as you made it is still not true.Rather, in that case the US may need a substantial increase in any one of tax revenue, economic growth, or inflation, or a substantial decrease in interest rates. There is no a priori reason to think it must be the first of these.

That flat rejection of spending within our means, is what’s got our creditors concerned. Not the prospect that we might stop going deeper into debt. They see a currency already weakening, and from their perspective, what’s the difference between our repudiating our debt, and inflating our way out of it?

Well, the difference is in one case, we’re actually repudiating our debt, whereas in the second case, you’re imagining inflation that doesn’t exist. And were creditors really concerned with “spending within our means”, they’ve had ample opportunity to signal that displeasure, starting in the early 80’s. Real Default != Monetarist Paranoia

Here’s my prediction if the agencies downgrade the U.S. debt: the GOP will spin that as the agencies’ concern about the amount of the debt (not the fear of default), hence as evidence that debt reduction—-> spending cuts (not taxes oh gosh no) should be our top priority. And the media will go along with that spin.

Yeppers. Welcome to Campaign 2012. Same for nonsense like voting on the Warren nomination.

The TI-92 can be sent back in time to terminate the guy who set the exam.
It’s not considered fair.

The US Constitution mandates that federal debt is to be honored. To default would be unconstitutional. Congress has mandated current spending. It is the law that the executive spend what has been legislatively approved.

It would be interesting to see the administration simply ignore the ‘debt ceiling’ and pay the debt and spend the money it has been told (by Congress) to spend. It has the tools to do so.

@12
“seeing an administration which openly repudiates it.”
The current administration is Obama’s. Are you talking about the bush administration? Where were the rating agencies during that administration?

(My reply to SoV was caught in moderation for some reason. Here it is again.)

Lemuel, can you run that by again?

There is a fuller explanation, including the derivation of the equilibrium condition, on my blog, which my name links to. You might also want to look at:

Arestis, P., and M. Sawyer. 2008. “The intertemporal budget constraint and the sustainability of budget deficits.” In J Creel and M. Sawyer (eds.) Current Thinking on Fiscal Policy.

and

Aspromourgos, T., D. Rees, and G. White. 2010. “Public debt sustainability and alternative theories of interest.” Cambridge Journal of Economics 34(3): 433.

I too had a look at that thread, and it looks to me like Henri’s characterization is fair. This is from April 19th. Here’s the post in its entirety:

“

… It was pretty silly when Standard & Poor’s started wagging the finger at the UK and expecting to be taken seriously. Trying to do the same thing with respect to the USA is pretty much the definition of tugging on Superman’s cape.

At least one economist burst out laughing on hearing about the S&P announcement. “They did what?” exclaimed James Galbraith, a professor of economics at the University of Texas in Austin, who formerly served as executive director of the Congressional Joint Economic Committee. “This is remarkable! It certainly will confirm the suspicions of those who have questioned S&P’s competence after its performance on the mortgage debacle.”

I can confirm that although it was “at least one” economist that burst out laughing, it was not “at most one”.”

Galbraith is seeing this from an MMT perspective, within which the US should just print the money. Even from an orthodox Keynesian view, the US could just print the money, within reason, under current conditions. Unfortunately, this is up to the Fed. Really, though, we and the Democrats should talk up just printing the money and get the idea to respectability (not achievable by August, unfortunately).

Oh, and while we are at it, the statement that “John Maynard Keynes argued that surpluses should be accumulated during good years so that they could be spent to stimulate demand during bad ones” is completely, demonstrably false. It’s equivalent to saying, “John Quiggin argued for a strong form of the efficient market hypothesis.”

(And, does anyone else find it slightly odd that an essay called “Reading Keynes in Brussels” doesn’t manage to cite anything the guy wrote?)

bobbyp, I agree with you except that I don’t see how the schema you outline does not come down to it’s up to the Fed. The Fed gets to decide whether it’s going to buy those Treasuries, and, if it does, whether it’s going to retire the debt or resell them later.

Come to think of it, even if the Fed monetizes, the bonds must be issued, which might technically violate the debt limit, albeit temporarily. Does anyone know if this can fly?

I think this is more a test of precisely how functional the US government is, and how long people go without deciding that Congress, especially Senators, need the lash of true pain–despite the pain it would cause everyone else.

I also think that bond market personnel is much less sympathetic to Republicans than people give them credit for. At the end of the day, no matter the narrow delusions about their relationships wrt to government regulations and taxation, they are invested in having a responsive government, and are more than most, aware of what dysfunctional government really means. Those guys? They want GDP growth, and they want it more than whatever they can loot from the US populace. More specifically rentier types that are the really bad sort of parasite, of course, doesn’t really care, so long the money keeps coming and power keeps accruing.

Insolvency vs default

My understanding is that failure to raise the debt ceiling could force the US into a position of insolvency, of being unable to meet all of its many obligations, but has nothing specific to do with default, the failure to meet obligations to creditors.

Unless the US has almost no freedom to defer other of its many obligations besides actual debt, I can’t imagine that the insolvency we are told will occur on or about 8/2/11 would result in default on US debt. My understanding is that debt service is only 10% of govt obligations, and therefore you would think that the choice could be made to not honor other obligations, and such choices could keep us under the debt ceiling. If nothing else, payments of principle on debt are the one sort of obligation payment that is debt-ceiling neutral, in that if the US makes such a payment, that much debt is cleared and there is that much more “room” under the debt ceiling to roll over and incur fresh debt.

And I would imagine that the reluctance to default on actual debt per se (as opposed to other obligations), is a function more of potential downstream insolvency than of fears for the national credit rating. If the US fails to pay creditors, those creditors might be pushed themselves into insolvency, and so on in a self-propagating chain reaction.

Unfortunately, stories about this debt ceiling pseudo-crisis never seem to talk about such practicalities as how much freedom the US has in deciding which obligations to meet or fail to meet, and what sort and magnitude of obligations would have to be set aside (postponed, presumably) to keep from actual default on actual debt. Other practical questions such as: the magnitude of debt owed to what sort of creditors, the likelihood that these creditors would be forced into insolvency by US default, what sort of resolution authority the US has over these entities in case we render them insolvent by choosing to default on their loans in particular, etc., go unasked and unaswered in such discussions. If anyone has any such answers, or can point me in the right direction, that would be appreciated.

JQ: “holding interest rates down is …problematic in the context…of a recovery” – please can you spell out in what sense problematic?

The central bank can presumably adopt a policy of targeting a given yield curve based on what near-term (actual or potential) growth is expected to be – ie with rates increasing as growth returned. Of course this might still entail a degree of monetisation going forward (although it’s not obvious a priori how much monetisation if any there would be, if the CB switched to targeting price rather than quantum) – and so broad money monetarists would obviously cry foul. But against “quantity of deposits” concerns of too much money chasing too few goods, you have (i) automatic stabilisers kicking in, and (ii) the fact that private sector deposits may well be close to endogenous anyway (ie empirically it appears that the private sector is quite able to rid itself of its excess deposits by paying down bank debt, including via bond-for-loan refinancing).

But ultimately, what’s wrong with switching the paradigm towards seeing tax (and net bond sales) as a demand management tool rather than a means of funding?

I accept that this paradigm might not necessarily lead to any different policy recommendations (a point JQ has made before). But Krugman’s argument “look, current yields prove there are no bond vigilantes lurking” is always susceptible to the riposte “but given how harmful they can be, it is rational to act as if they could return at any time – so let’s cut govt spending”. Much stronger is to argue that bond vigilantes cannot do any harm anyway, since the central bank can offset their effects without fear of inflation taking off.

@Brett 45

Since the militarism budget is over 50% of discretionary spending and has been declared sacrosanct despite the conspicuous lack of any real threat, cutting spending is not very likely.

Since the GOP has decided to engage in tooth fairy economics and believe that cutting taxes raises revenue, there is no prospect of improvement there until the GOP have lost all ability to set policy.

Yeah, what’s “sacrosanct” is exactly the problem…

“But ultimately, what’s wrong with switching the paradigm towards seeing tax (and net bond sales) as a demand management tool rather than a means of funding?”

Absolutely nothing. Given that we have a government monopoly fiat currency and let it float freely against other currencies, that is exactly what we do now. We just discuss it stupidly.

So Brett Bellmore seems to think the govt could run a balanced budget starting tomorrow, all via spending cuts.

Is anyone else able to distinguish this from trolling?

Brett, the budget has been set. Commitments have been made. Projects have been embarked upon. For the government to stop borrowing in August would not be the beginning of fiscal responsibility. It would be the government reneging on contracts and commitments, and doing so unexpectedly. It would be a terrible case of government irresponsibility which would plunge the world into a depression.

The time for negotiating on the budget has passed us. Using the debt ceiling at this point in the fiscal year as a negotiating tool is gross incompetence, a betrayal of the public trust, and very close, ethically, to a form of treason.

I think we should start a “worst offenders” list on this subject, and pour campaign contributions to their political opponents. Grossly irresponsible rhetoric about a matter like this, while the economy wavers between a second recession and sluggish growth, should have a political cost.

Well, Brett does have a point about our inability to cut defense spending, but yes, there seems to be a good bit of wishful thinking going on.

The only possible way to see that side is if we cut spending on defense in the current budget cycle to offset the huge deficit from everything else. And while that might save some entitlements (and countless poor and needful persons, and children) it would be difficult to recoup even a fraction of what is being spent elsewhere. Not to mention extended foreign military engagements and Medicare. The numbers just won’t add up.

We could call it the austerity fairy, or something. If you leave a note under your fiscal pillow, your debt is magically wiped away and everyone still gets paid! Whee!

Doh! Nice catch, Walt.

Back to the main point, I just can’t see the ratings agencies doing anything that would jeopardize the Bond Markets. And I can’t see the Republican legislature “sanely” destroying short-term market gains and expecting to be funded for the 2012 election cycle, so from where I sit, default is a very low, but humbly admitting not zero, probability.

This subject makes me totally bonkers. Why isn’t Obama on the TV explaining the consequences of default, or of dragging this out as long as the GOP seems intent on? Americans are poorly informed, but if he made a concerted effort, the media narrative would change to align more with reality. Instead, he is intent on using a milder version of the Republicans’ own Debtpocalypse rhetoric, and letting them run roughshod over the economy.

Tim Worstall – I honestly meant it as a lament, not a put-down. You are certainly in otherwise enlightened company when you refer to taxes as a funding activity, but you strike me as possibly more enlightened and certainly less of an establishment lackey than Krugman, so it would seem easier for you to change your paradigm, professionally speaking, than Krugman. But you clearly just haven’t been convinced by the MMT spiel – which is ultimately the failing of Wray et al.

Walt – oops, forgot the rule DFTT.

Didn’t you all say a few weeks ago that downgrading the US debt is a ridiculous idea, and there can be no default under any circumstances?

John didn’t, I did, and I still believe it. I think we’re on common ground that any actual, money-lost default is pretty absurd. I, on the other hand, also believe that even the technical, couple-of-days-late default is also absurd – there are a lot of things that the Treasury can do to keep paying debt, and they will do them.

The economy is stupid isn’t it.

“spending commitments made years ago cannot be funded”, as if the US govt were just another user of someone else’s currency…”

But Anders, ‘spending commitments’ are not about producing currency, these are commitments to provide things that can be just as hard to get as someone else’s currency.

As other commenters have noted, failing to raise the debt ceiling threatens to put the U.S. into a position of insolvency, not default.

An insolvency is, implicitly, a threat to the stability of the economy and/or the stability of the currency. In that sense, it would make more sense, for S&P, Moody’s, etc., to re-rate all dollar debt. U.S. government obligations are at no particular risk of default and a relative rating of AAA (if AAA is considered a mark on a relative scale) would remain appropriate, but the economy is threatened, so private debt and equity securities — particularly those denominated in dollars and tied to real activities in the U.S. economy — are subject to elevated risk. A deflation would threaten a vast array of private business activities. So, logically, if the ratings agencies were on the ball, they would be considering a re-valuation of all values. (Nietzschean economics, anyone?)

“Or do you need someone to explain why?”

Yes, you will need to explain why.

Just to repeat my position: Why does the US need a substantial increase in tax revenue in the future? Because a number of promises have been made about what will be government spending in the future. SS is part of this but the much larger part is Medicare.

Contributions have been collected from the citizenry in return for promises of future medical treatment. For some reason ( we can have lovely fights over what: maybe it’s the increasing lifespans, not previously accounted for, maybe it’s the medical cartels or the market based system or maybe it’s just the typical politicians promising lots but not being will to charge for lots. Good way to gain votes that.) the money that has been/is/will be collected isn’t enough to pay for those promises.

Thus the Government can do three things: it can reduce those future promises. This is known as “cuts”. It can raise taxes and pay for those promises. Or it can borrow more money.

At some point (an arguable one, what the point is) the government cannot borrow more money without it being self defeating. Changing the set up of the health care system (these insurance exchanges, a move to single payer, whatever) would be a “cut”….perhaps not a reduction in health care as it is delivered but a change from what was originally promised. Or taxes can rise.

JQ is arguing that taxes must rise. I’m agreeing, on the assumption that cuts or more borrowing aren’t possible/going to happen.

But of course Medicare is not a promise of a sum of money. it is a promise of medical treatment. If medical treatment can be delivered with a slower rise of medical costs, that is not a cut. Nobody promised medical inflation 0f 6% or 8% per year.

Anders, suppose your monetary magic brings the unemployment rate to 0%. Unfortunately, it’s still a distinct possibility that, say, the two top quintiles get to consume pretty much everything produced in the economy, and therefore government’s commitments (assuming they are of an egalitarian nature) are still not fulfilled. 0% unemployment doesn’t sound too realistic, but apart from that this seems like a likely scenario, doesn’t it. Under these circumstances, do you agree that the government will have to tax in order to spend?

Well, I don’t find it too difficult to imagine. I don’t think ‘full capacity’ necessarily implies any particular pattern of income distribution.

Further, tax revenues, under such conditions, would presumably be robust.

So, then we do agree that spending needs to be, generally, financed by taxes, whether you use your own currency or not?

Barry, I’m only addressing the plausibility of Lemuel’s specific calculation, which assumes that the government runs a primary deficit as a fixed percentage of GDP every year, etc., not any other budget scenario.

“Or do you need someone to explain why?”

Yes, you will need to explain why.

Just to repeat my position: Why does the US need a substantial increase in tax revenue in the future? Because a number of promises have been made about what will be government spending in the future. SS is part of this but the much larger part is Medicare.

Shrug. Let the record show that I did not coerce, trap, or trick Tim in any way. To proceed, the original post was:

“Sadly, we still have intelligent types like Tim Worstall saying “spending commitments made years ago cannot be funded”, as if the US govt were just another user of someone else’s currency…”

To which Tim replied:

Well, I dunno if that’s quite the put down you think it is. Paul Krugman (definitely an intelligent type) has been telling us for years that we’ve got to sort out the health care system because the current Medicare promises can’t be paid for without raising taxes…..which of course is his justification for health care reform and “bending the cost curve”.

‘Scuze me? Anders points out that people like you say that previous spending commitments cannot be funded, despite the U.S. being just a little different from your regular lender, and you say that’s not true; taxes can be raised?

Hello in there. In what universe can someone like me raise taxes to cover my previous spending commitments? For that matter, in what universe can someone like me simply print more money, etc. to cover my previous spending commitments?

Did you even think in either case before you posted?

Who really cares what Moody’s or S&P says? Their treatment in the press like autonomous, looming powers is just a tactic in conservative image management. They work for the rich, they press policies that will be good for the rich (like, oh, keeping tax rates low for the rich), and you can make your logical deductions from that. They exist by sufferance of the U.S. government, actually. The government could, in 2009, have investigated their enterprises and utterly reformed them – and they need massive reform – but they are too valuable as supposedly objective sources, little calculating machines from outer space, instead of subordinates of the various giants of the financial industries sector.
However, they have another function, too, which we shouldn’t forget. Every con game needs a validator, who, in old fashioned parlance, is used to route the grift. How are you going to fleece people if you don’t have ‘grades’ for your bets – here’s the A tranche, and here’s the C. It looks so scientific! Surely these people know what they are doing. Routing the grift is one of the booming industries in America. That’s a problem. U.S. issued debt, not so much.

oops, I don’t know why that suddenly submitted. Anyway, I remember in the old days – way back in 2009 – when the rules were suddenly changed as to how banks judged their assets. Hell, I’m old enough to remember all the rule fudgery of the 2008-2010 period. A rule is only as stringent as its political usefulness, and it would be, as we all know, a one day wonder if the rules on AAA assets changed, followed by … nothing.

Here’s how hard and fast rules evaporate, from the Washington Post,
April 9, 2009 – In this blogpost http://www.bankreorealestate.com/legal-news/under-new-fasb-accounting-rule-toxic-assets-may-be-revalued-by-banks.html

“The board that sets U.S. accounting rules voted yesterday to let financial firms report higher values for some troubled assets, a controversial step likely to increase some banks’ reported earnings but also heighten suspicions that the companies are concealing problems.

The move by the Financial Accounting Standards Board was made with unusual speed under intense pressure from Congress and the financial industry, which have argued that the old rules exacerbated the financial crisis by forcing banks to overstate expected losses.”

As I say, the rules create an ‘objective’ crisis, when the crisis is useful politically, and create a problem which is solved, when the rules are politically inconvenient.

Henri V: if we want to boost the income of the poorest 60% with various monetary benefits, we need to be careful not to unduly boost overall purchasing power relative to the level of goods and services offered by the economy, by taxing away some purchasing power from the richest 40%. Even redistributive taxation isn’t a funding activity!

Roger, not all rules are equally easy to change. Even the rule change you note was instituted many months after the worst of the financial crisis hit – after enormous damage had been done.

Whatever your opinion of ratings agencies, their judgments are built into an enormous number of private agreements, regulations and laws. Should US debt lose its triple A, the damage will occur too fast for any rule changes or even simply institutional coordination to be implemented. Everything will happen very quickly and will – imho – accrete exponentially.

I believe that it is the predictably catastrophic consequences of a default that cause many to discount heavily the possibility of a default. And it’s certainly true that the President has certain options should Congress refuse to lift the ceiling by a certain date. But the use of those options would be problematic in itself, as it would change the riskiness of US debt.

I only hope that those politically responsible for pushing things this far end up paying a steep political price in lost fundraising, lost institutional support, and ultimately lost votes.

#94. The main Presidential options I see is stop paying creditors and/or ax spending suddenly, both drastic, highly destructive, and hard to implement. The Fed has the option of monetizing, but is deliberately protected from political pressure to do so. Ben can tell Barack to stuff it. Since it is a matter of interest to the financial sector, not just the public, Helicopter Ben might fly to the rescue once again. But if there is another way to protect Wall Street, there will be no help from that quarter.

“So, then we do agree that spending needs to be, generally, financed by taxes, whether you use your own currency or not?”

No. The reverse. Government has to spend first to collect taxes. As the issuer of its own currency, the government can purchase anything the real economy is capable of producing. Unlike any actor in the private sector, it is financially unconstrained. Taxation serves a different purpose altogether.

“I’m still hoping for someone in this forum to counter-argue…”

Not sure…but the central bank could always hold down short term rates even with the economy running at full steam. Depending on what else is happening (tax and fiscal policy, etc.) this could have negative economic consequences……so it depends on the assumptions you start out with.

“One of the nice things about this thread is that predictions are being made…”

I’d like to see the Administration ignore the debt ceiling altogether and have the issue go to the Supreme Court and/or the impeachment route. Alas, that won’t happen. There will be a messy compromise…possibly involving a lot of not quite firm commitments to ‘doing something’ about those terrible ‘future commitments’….kabuki dance…then back to normal.

Andrew and John Q. – your scenarios would be believable if rule resets were about the U.S.’s chronic inability to pay. However, they aren’t – this is more like a Y2K problem than the Greek problem. The latter is chronic, the U.S. problem will just be using the debt limit as a political football. Perhaps traders are autistic types with short term memories and no sense of the future, but I doubt it. Rule reset would be seen for what it is – a back way through a temporary political problem that, granted, would cause a lot of rentseeking short term activity on the markets – why not make some easy money – but that will simply have no long term effect.

So, you would have a flash crash at most. This is a nothing problem. As for the suddenness of it – I don’t know, I’d be surprised if there isn’t some team at Treasury working out the terms of a rule reset right now.

Andrew,

Why would there be a sell off? There is no question that principle and interest shall be remitted in full. A fund manager would be in deep trouble selling fund assets of such undoubted quality into a panicked (or so you assume) market. It would be an act of fiduciary folly bordering on criminal negligence.

It bears reminding, but you know the Fed actually control interest rates, and it could offer to buy the bonds at high prices and those who simply “must” have AAA rated securities could console themselves with cash (a financial instrument quite safe from the depredations of the ratings agencies I hear) or rush to bid up the price of Exxon first debenture bonds. So tell me…in such circumstances, would the price of those bonds go up or down?

Thanks.

Why, given your scenario, I bet Goldman Sachs is assembling a gigantic leveraged long position in AAA corporates right now!

Anders: Even redistributive taxation isn’t a funding activity!

I thought you’d say this, but isn’t it just a matter of framing, and, in the end, amounts to the same thing?

If you want to change the pattern of consumption, (for a given level of economic activity), you need to take money from one group and give it to another group. Take out of circulation and return to circulation. Tax and spend. Does it make sense to argue about terminology.

bobbyp @102, as I said, imho there is a very small probability of a US default. As to what investors and traders are doing with respect to that probability, I don’t know. I do know that Pimco exited US bonds in the near past.

I’m less sanguine than you are for two reasons. First, you’re assuming that there is sufficient managerial discretion at all of these entities to enable them to continue to hold US debt even in the event of a downgrade. Depending on the relevant agreements, that may or may not be the case. Second, you’re assuming that the correct act of discretion would be to continue to hold US debt in such an event. On this second point, though, the conservative move would be to sell immediately and buy other securities (unless the probability of a sell-off is so low that the absolute value of the expected value of the loss to a position from a sell-off is less than etc.) . If there is a sell-off, then you got out early; if there isn’t a sell-off, then you didn’t lose much when you sold. Finally, third, even if there isn’t an immediate sell-off, many entities would likely reduce allocations for US debt.

As to the Fed stepping in to buy… I find myself in favor of additional quantitative easing these days, but without having seen the results of someone more knowledgeable than me crunching the numbers, I’m dubious that the Fed could really do this quickly enough and at scale enough to support the price. It would be a very short-term support, regardless, and once sufficient inflationary expectations are attached to the purchases, it all becomes self-defeating.

Tim Worstall: this is controversial because you continue to put the cart before the horse. For taxes to ‘fund’ spending for a person, there needs to be a difference between the person having and not having money. This difference is coherent for you, me, General Motors or Greece, but not for a sovereign currency issuer with no foreign ccy debt.

It may well be that, if we want to honour spending promises, we will need to increase taxes in due course – but this should only be driven by inflation concerns at the time, and should be determined ex post, not a priori.

Salient,

I share your guilty pleasure.

bobbyp @107: As I’ve said, the chance of a default is extremely small. This is a highly unlikely event. Nothing I’ve said would predict sellers at this point.

The question at hand was whether, should this very unlikely event occur, i.e. should the US actually default, the consequences would be grave or not.

You say that the sellers cannot all hit the exit at once. My answer is that they certainly can. Moreover, the nature of a forced sale practically requires that they do.

You say that the Fed has engaged in massive purchases already without substantial inflation. That’s very true. I don’t think we disagree on that. That doesn’t imply that the Fed can begin doubling or tripling its holding of US treasuries in August without negative consequences.

Finally, as to QE3, I’m not sure I understand your point re zero bound. Quantitative easing is used when the zero bound makes more conventional interest rate targets useless for stimulating economic activity. So yes, I agree that the zero bound lowers the probability of success of more conventional monetary policy; hence QE3.

Bobbyp, yes, I think the downgrade, as well as the default, are highly unlikely.

Those forced into selling would be those required to own AAA rated securities. There are plenty of market participants who will not be subject to such requirements.

As to quantitative easing generally, the type used in the US wasn’t simply focused on increasing the money supply. Instead it was focused first on increasing particular types of credit for businesses and households, and focused second on increasing the wealth of households and investors. These two efforts led to increased wealth and consumption, and lowered savings rates. As it has wound down, the effects have as well.

As to Japan, I think it’s in such a different position – I’d imagine that their bonds are held in larger percentage by domestic entities (95% or so) and that those entities are less free than those in the US might be to begin dumping them, among other things – but I haven’t spent much time on the case.

It might be Bobbyp. It all depends on what’s in some of the various investment agreements, guidelines, and regulations regarding triple-a securities. And there’s nothing wrong with agreeing to disagree, or having less than absolute proof on a point. This is a comments section on a blog, after all, and we both have lives.