(Bloomberg News) A U.S. default triggered by the failure of politicians to agree to raising the country's debt ceiling would be an "act of collective insanity" with severe impact on asset prices and the global economy, according to Citigroup Inc. economists.
The prospect of a default by the U.S. government, while still remote, is no longer negligibly small, wrote Citigroup Global Markets economists led by Willem Buiter. A default would "severely" damage the country's role as an international financial power and as provider of the world's reserve currency, they said. The political division is so wide that there is little chance of a meaningful agreement on addressing the long- term debt problem any time soon, making a downgrade of the country's AAA credit rating "likely" even without a default.
"A default because of a failure to raise the Federal debt ceiling would be an act of collective insanity," Buiter, London-based chief economist for Citigroup, wrote in a note dated July 28. "The implications of even a technical U.S. default are likely to be severe both for the U.S. and the world economy, involving a widespread rise in public and private funding costs, a generalized fall in asset prices, and a large hit to economic growth."
House Republican leaders scrapped a vote on the debt- ceiling bill Thursday night in Washington, indicating that Speaker John Boehner is short of votes needed to pass his proposal amid a vow by Senate Democrats to defeat the measure. The delay fueled concern that a compromise by the two parties won't be reached before the Aug. 2 deadline for a possible U.S. default.
Citigroup ascribes a 5-percent likelihood to a default triggered by the impasse, according to the report, which was issued before the vote was delayed. While a default by the U.S. would probably be only "technical" in nature and any missed payments repaid within days, its effect would not be benign, the economists said. The event would fall into the hitherto unprecedented class of a "needless" default, as opposed to those caused by "bad luck" or a refusal to pay.
"We would be surprised if the markets were lenient," the economists wrote, drawing parallels with a 1979 failure by the U.S. to meet some interest payments. "Increases in U.S. rates at all points of the curve are likely to be relatively large and to persist for years. Financial conditions could worsen sharply and interbank, credit and other funding markets are likely to "freeze"."
"As a result of the financial turmoil, the negative wealth effects, the increases in costs of capital and the substantial hit to sentiment, the U.S. dives into a deep recession, taking the rest of the world with it."
Rating Downgrade Likely
The most likely scenario, with a 60-percent likelihood, according to Buiter's team, is one where the debt ceiling is raised with a bipartisan agreement that saves up to $2 trillion over a decade. Such a deal would still trigger a downgrade of the country's long-term credit rating to AA, which in turn would mean downgrades of other asset classes including municipal bonds and those of financial institutions "whose ratings rely on an assumption of systemic support," the economists said.
"There can be little doubt, in our view, that the readiness of most investors to hold, let alone add, to their holdings of U.S. Treasury securities at any given level of yield will fall in response to a downgrade," the note said.
"The consequences of a moderate downgrade are likely to be far less damaging than those of a default. But they will still be substantial, including increasing funding costs for the U.S. sovereign, many related public entities and many related or unrelated private companies."