What Does "Default" Mean?

| Tue Jul. 26, 2011 8:11 PM EDT

Dan Drezner says he's been "flummoxed" by the lack of market reaction to the stalemate over the debt ceiling. He suggests that it might be because U.S. bonds are mostly held by central banks and sovereign wealth funds who aren't likely to sell them in a panic regardless of what happens. So default isn't as big a deal as we think it is.

Maybe. But I think it's because we're throwing the word "default" around too casually. There are two ways people have been using the word lately:

  • That the United States will actually stop making interest payments on outstanding bonds. This would be a disaster, but it's also pretty much out of the question, since Treasury will prioritize coupon payments over everything else even if Congress stays stalemated for a while. So markets are quite rationally not very worried about this.
  • That the federal government will stop paying some bills on August 2nd. This is much more likely, but Wall Street has seen this movie before: it's roughly the same thing that happens whenever the government gets shut down because a budget hasn't been passed. It's a bit of a mess, but when checks stop going out and offices start getting closed, the political pressure to get things moving goes up exponentially and before long the stalemate ends one way or another. From the point of view of the bond market, it's nothing to get in a tizzy about.

Beyond this, there's the idea that bond markets should be troubled by our long-term financial problems. But they haven't been in the past, they aren't now, and Standard & Poor's to the contrary, nothing happening now really suggests they should be much more troubled about it than they've ever been. Maybe someday they will be, but that day is a ways off.

In other words, maybe there's just not much reason for bond markets to be panicking yet. A downgrade by the ratings agencies would be a more serious thing, especially since it would have knock-on effects on state and local bonds, but I suspect investors are treating that as a completely separate issue. Not: are U.S. bonds in trouble? but: what are S&P's analysts going to do? And for the moment anyway, investors apparently think their downgrade talk is just bluster. Perhaps they know something we don't?