To raise or not to raise the debt ceiling; that is the question: Whether ’tis nobler to suffer the slump and arrows of default today or in some distant future. Oh, bards of Washington, give us your answer.
This Shakespearean financial dilemma hangs in the balance between now and a somewhat theoretical Aug, 2, but I can tell you what an unbiased investment manager thinks: Don’t mess with the debt ceiling. Raise it unencumbered if necessary. I say unbiased because my credentials have become very public over the past several months. Pimco owns very few Treasury securities, and its clients would theoretically benefit if yields rose on an under-owned asset class that was technically in default. But default would still be a huge negative for the U.S. and global financial markets, introducing fear and unnecessary volatility into the economy and global trade. The market situation might resemble what happened after Lehman Brothers collapsed in 2008.
Congressional Republicans and GOP presidential candidates almost unanimously dispute this conclusion. House Speaker John Boehner sums up the Republican position best, saying that “it is true that allowing America to default would be irresponsible. But it would be more irresponsible to raise the debt ceiling without . . . taking dramatic steps to reduce spending.”
Responsibility in this case, however, is not an either/or proposition. An actual default — or even the threat of one — might set off a chain reaction that would raise Treasury bond yields by 25 basis points (a quarter of a percentage point) or more, pushing up the cost of debt throughout American financial markets. Moody’s, the bond rating agency, just Wednesday put America’s AAA credit rating on review for potential downgrade, roiling equity and bond markets alike in the aftermath. If an extra 25 basis points becomes the new benchmark, federal interest expenses might increase by $30 billion to $40 billion annually over the ensuing years as $1.5 trillion of new debt is issued each fiscal year, complicating efforts to narrow budget deficits.
Bond investors are a conservative lot. They earn only 1.6 percent on the average Treasury maturity these days, but they expect certainty on when, and whether, they will be repaid. Countries that keep them guessing or that are expected to default are punished severely, as reflected in 20 percent bond yields in Greece or even 5 to 6 percent in AA-rated Italy. Like it or not, James Carville, global investment managers have global choices these days, and a solvent Germany or Canada is just a wire transfer away for trillions of potential investment dollars looking for a safer haven.
There is an additional concern. The U.S. dollar is the global reserve currency, producing daily liquidity for trillions of dollars of transactions between trading nations. The greenback earned that status from decades of balance-sheet conservatism and strong economic growth. Now, as the ratio of federal debt to gross domestic product creeps closer to 100 percent — symbolic of AA, not AAA, status — and our growth rate remains mired at a 2 percent annualized rate, countries that have reserve surpluses (China and a host of petroleum exporters) are rethinking their currency preferences. A ratings downgrade or an actual default could reduce the willingness of these countries to do business in dollars, jeopardizing trade receivables and overnight letters of credit in the process. Recent defaulting sovereigns such as Argentina and Russia prove that commerce is difficult to restart once a seller is unsure of being paid in a currency that represents a store of value and is considered “money-good.” If our government doesn’t give a damn about the greenback dollar and its solvency, why should we expect others to protect its status as a reserve currency — a privilege that, by the way, lowers our interest expenses by an estimated $30 billion annually?
The answer to our modern-day Hamlet’s question then, is that there should be no question at all. The debt ceiling must be raised and not be held hostage by budget negotiations. Don’t mess with the debt ceiling, Washington. Bond and currency vigilantes will make you pay.
The writer is founder and co-chief investment officer of the investment management firm Pimco.