If congressional leaders wreck the government’s credit by defaulting Aug. 2, they wreck everyone else’s credit, too. Failure to raise the debt ceiling soon will cause Uncle Sam’s credit score to plummet into subprime range. Every American’s credit effectively takes a dive as well. Interest rates will rise as if everyone’s credit score suddenly dropped 50 points or more.
This rate increase won’t affect the lucky borrowers who already are locked in at the historically low mortgage rates we’ve had during the past two years. But it will choke off new borrowing by pricing many others out of the housing market.
More broadly, the economy desperately needs a new infusion of credit-driven spending to breathe life into a fading recovery. Forget about that happening if interest rates spike.
And that’s not the end of it.
Millions of homeowners who haven’t been able to refinance out of their adjustable-rate mortgages may be in for a very nasty shock this fall. An interest-driven increase in their mortgage payments, in the face of an already-weak economy, will doubtlessly push thousands more homeowners into default and foreclosure.
Government bond rates could skyrocket as cautious investors dump their U.S. bonds and refuse to buy more. Take a look at the rates on Greek or Portuguese government bonds these days for an idea of how bad things could get here.
If government bond rates rise, this will jack up all interest rates, even though individual borrowers aren’t any riskier. Banks and other lenders can’t adapt very quickly to a surge in these benchmark rates, so they’ll simply pass the cost along to borrowers, at least in the short term.
That nightmare scenario may be enough to get Congress’ attention. After all, they still have a couple of weeks to get their act together and avert a default. Let’s hope so.
But good credit is built on good faith — borrowers need to show that they take their credit obligations seriously. If anything, Congress’ actions show contempt for the loans it must pay and the people who lent the money. Members of Congress basically ignored the actual event of reaching the debt ceiling, knowing they could ask Treasury to use accounting gimmicks to buy some time.
And the two months since then have been filled with posturing based on extreme positions. Even now, despite the fact that it’s crunch time, there seems to be a real chance that a deal won’t get done in time to avoid a default. This uncertainty undermines investors’ faith in the U.S. government, which is the ultimate source of its good credit. Even if we emerge without defaulting, it’s likely there will be lasting damage to America’s reputation in the global capital market.
Congress seems to take it for granted that willing lenders and ready cash will always be there whenever it needs to borrow. That certainly used to be the case, but the world is changing fast.
Now that the Fed’s latest government bond-buying spree has ended, we’re about to find out who still wants to buy U.S. bonds, and at what price. Foreign investors, particularly the Chinese, are significantly decreasing their new purchases of U.S. government debt. There are plenty of other borrowers out there now with better economic prospects than the United States and who are more eager to keep their lenders happy.
Our leaders need to understand that averting a government default is not just about cutting another budget deal. It’s about restoring the full faith and credit of the U.S. government, which they have put at risk.
Connel Fullenkamp, a professor of economics at Duke University, was a visiting scholar and consultant at the International Monetary Fund’s IMF Institute in Washington.
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