Debt Ceiling Catastrophe?

August 2, 2011 is the date given by when the federal government will run out of money to pay all its obligations – including social security checks, government employee salaries, interest on borrowed money, etc.  The message has been that without the ability to borrow more to pay the obligations by raising the debt ceiling, catastrophe awaits.  Foreign countries holding  U.S. government bonds have been wagging their finger at the U.S. to not default or else.

If a borrower is about to default, no one in their right mind would want to lend to such a scammer.  Greece, which will inevitably default for sure either this year or next, is able to tap money by offering a 16 percent interest rate (which in my view is a sucker bet since Greece will not pay what is promised).  As for the U.S., the government borrowing rate is still very low.  The U.S. can borrow at a 0.35 percent interest rate on a 2 year loan and 2.9 percent on a 10 year.  These rates are at near-historic lows.  However, given all the talks of impending doom and with Washington politics not getting any closer to a budget deal, are investors continuing to be unconcerned about a U.S. default?

Perhaps the investors, including the Chinese — one of the biggest purchasers — only talk the talk but are not willing to walk the walk.  That is to say, global bond purchasers are very content to lend at low interest rates to the U.S. government and are not a bit apprehensive about not getting the money back and with the specified interest.

Let’s take a look at what might happen.  If August 2^nd comes around and the government defaults, will the Chinese investors panic?  Or would they trust that the U.S. will eventually honor the obligation at even if the payment deadline is delayed a bit?  Based on the current appetite for U.S. bonds, global investors are saying that they are perfectly fine with delayed payments, provided the principal and any accrued interest are paid at some point in the future even if the date is unspecified.  After all, most global bond purchasers have been simply recycling money back into the Treasury once the maturity date arrives.

My guess, therefore, is that come August 2^nd there will be no panic or economic chaos.  Standard and Poor’s and rating agencies will squawk about downgrading the U.S. to a lower rating, but who is listening to them anymore after they gave top, AAA ratings on just about every subprime mortgage collateralized debt obligation that went bust?

However, if the debt default was to continue on for two to four months and truly raise uncertainty in the global investors about when they will get their money back, then a major economic headache is possible.

In other words, don’t panic in August.  But do start to worry in October.