Rollover Risk: Ideating a U.S. Debt Default

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday September 23, 2013 at 9:00 am
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Editor’s Note: The following post comes to us from Steven L. Schwarcz, Stanley A. Star Professor of Law & Business at Duke University School of Law.

In Rollover Risk: Ideating a U.S. Debt Default, forthcoming in the Boston College Law Review, I systematically examine how a U.S. debt default might occur, how it could be avoided, its potential consequences if not avoided, and how those consequences could be mitigated. The impending debt-ceiling showdown between Congress and the President makes these questions especially topical. The Republican majority in Congress is conditioning any raise in the federal debt ceiling on spending cuts and reforms. Yet without raising the debt ceiling, the government may end up defaulting, perhaps as early as mid-October.

Even without that showdown, however, these questions are important. As the article explains, certain types of U.S. debt defaults, due to rollover risk, are actually quite realistic. This is the risk that the government will be temporarily unable to borrow sufficient funds to repay—sometimes termed, to refinance—its maturing debt.

Because rollover risk is such a concern, one might ask why governments, including the United States, routinely depend on borrowing new money to repay their maturing debt. The answer is cost: using short-term debt to fund long-term projects is attractive because, if managed to avoid a default, it tends to lower the cost of borrowing. The interest rate on short-term debt is usually lower than that on long-term debt because, other things being equal, it is easier to assess a borrower’s ability to repay in the short term than in the long term, and long-term debt carries greater interest-rate risk. But this cost-saving does not come free of charge: it increases the threat of default.

The article also examines how the U.S. government could avoid default, discussing steps—such as monetizing its debt and printing money to pay maturing debt—that it could take to facilitate debt repayment. At the very least, however, these steps are likely to spark inflation. Moreover, the government’s flexibility to print money to avoid default could change in the future if the dollar loses its role as the international reserve currency

A U.S. debt default would have severe economic and systemic consequences, causing the stock market, the bond market, and the value of the dollar to plummet, at least in the immediate aftermath. Credit markets would likely freeze, harming both companies and consumers. The downgrading of credit ratings on U.S. debt would also make it much more difficult and expensive for the country to borrow.

Even a mere “technical” default—temporarily missing an interest or principal payment due to illiquidity—could harm the real economy. J.P. Morgan recently issued a report concluding that such a default would “almost certainly have large systemic effects with long-term adverse consequences for Treasury finances and the U.S. economy.” At a minimum, the United States would likely see a one percent reduction in gross domestic product (GDP) due to higher interest rates and a likely equity selloff. The default also “could leave lasting damage in its wake due to a permanent decline in foreign demand” for U.S. Treasury securities, which would “likely lead to higher borrowing costs and larger deficits.”

A U.S. debt default would also raise a host of legal issues, including questions of first impression under the Fourteenth Amendment, which prohibits the government from questioning the “validity” of its public debt. Creditors challenging a U.S. debt default would face procedural hurdles, including the need to overcome sovereign immunity, to establish a compensable remedy, and to enforce any resulting judgment against government assets in the face of executive branch opposition. Interestingly, foreign creditors might have better remedies than domestic creditors; under certain international treaties, they may be able to seize U.S. government assets to pay arbitration awards. This is significant because approximately half of all U.S. government debt is held by foreign investors.

The article also explores how the negative consequences of a default might be mitigated, potentially through a bilateral or unilateral debt restructuring or even through a possible IMF bailout. But bilateral debt restructuring, with the consent of both the government and its creditors, might not always be feasible in time to avoid default; whereas a unilateral debt restructuring would be tantamount to a default because creditors would not be paid on a timely basis according to their original contract terms. A bailout is also unlikely. Only the International Monetary Fund might have the economic wherewithal to bail out the United States; but even if otherwise feasible, an IMF bailout might not be politically acceptable if (as almost certainly would be the case) it is conditioned on IMF-imposed austerity measures.

Bottom line: There is no magic bullet to put an end to rollover risk. Prudent management of rollover risk should take into account stricter controls on the issuance of short-term government debt, as well as possible austerity measures to limit the government’s need to borrow.  The critical question is whether the United States has the political will and integrity to better manage its debt and rollover risk, before it defaults.

The full article is available for download here.

  1. [...] on the Social Science Research Network.  Professor Schwarcz also writes on this same topic on the Harvard Law School Forum on Corporate Governance and Financial [...]

    Pingback by Understanding the dangers of a debt default — October 3, 2013 @ 12:07 pm

 

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