How I Learned to Stop Worrying and Love Default

If the debt-ceiling negotiations (summarized here) drag on to the point where there is real doubt about the full repayment of Treasury securities, would that be a disaster? Or could it actually raise output and employment?

Nick Rowe has a very smart argument for the latter, on straightforward Keynesian grounds:

Take the standard ISLM model... Draw the LM curve horizontal; either because the central bank conducts monetary policy by setting a rate of interest, or because the economy is stuck in a liquidity trap where money and government bonds are perfect substitutes. Now let's hit it with a shock.

The shock is that all the bond rating agencies downgrade the rating on government bonds. Specifically, the rating agencies say that whereas the previous default risk was zero, there is now a 1% chance per year that the government will renege on 100% of all promises to pay money on its bonds. (Or a 10% chance per year of reneging on 10% of repayments, whatever.) And assume that everybody believes the rating agencies. Further assume that the central bank holds the interest rate on government bonds constant... What happens?

My answer to this question is the same as the standard textbook answer to the question where the shock is an increase in expected inflation by 1%. ... And if you: did believe in the ISLM model; and did believe that the economy was stuck in a liquidity trap; and did believe the economy needed an increase in Aggregate Demand; and did believe that fiscal policy either should or could not be used, for whatever reason; you would say that this increase in expected inflation is a good thing. At first sight, the answer to the question "what is the effect of a 1% increase in perceived risk on government bonds?" is exactly the same as the answer to the question "what is the effect of a 1% increase in expected inflation?". ... Both result in the same 1% fall in the real risk-adjusted rate of interest on private saving and investment and the same rise in AD and real income.

This is one of those points that seems bizarre and counterintuitive when you first hear it and completely obvious once you've thought about it for a moment. Suppose a bond already pays zero interest; how can its yield go lower? One way is for inflation to get higher, so the principal repayments are expected to be worth less. But another is for the default probability to rise, which also reduces the expected value of the principal repayments. At the level of abstraction where a lot of these debates happen, for important purposes the two should be identical. If you believe the zero lower bound story -- that monetary policy would have brought unemployment down to normal levels by now, if it were just possible to reduce the federal funds rate below zero -- then you should support a (temporarily) nonzero default risk on government debt for the exact same reason that you support (temporarily) higher inflation -- it creates the economic equivalent of negative interest rates.

There are lots of caveats in practice. (There are almost always lots of caveats.) And if you're a ZLB skeptic -- if you don't believe even a negative interest rate would be effective in boosting demand -- then default risk won't help much either. But analytically, it's still an important point. Among other things, it helps explain why the threat of default has not moved the price of Treasury securities at all.
I'd assumed, up until now, that it was because asset owners took it for granted that the debt ceiling would, in fact, be raised, or that if not debt payments would be prioritized over everything else.

I still suppose that's true. But here's a more general reason. Another way of thinking of the zero lower bound phenomenon is that the government's commitment to issue zero-interest liabilities in the form of cash and reserves sets a ceiling on the price of its liabilities (remembering that price and yield move inversely.) This price ceiling means there is excess demand. So if you have some exogenous factor that would normally lower the price of Treasuries, it doesn't do so; at the margin, it just reduces the backlog of frustrated buyers at the current price.

Cool.

UPDATE: And here, right next to the Rowe piece in Google Reader, is an FT Alphaville item about how settlement failures (not delivering a security at the date contracted) seem to be becoming increasingly deliberate in secondary markets for Treasuries, as a form of "unconventional financing." It's not an exact analogy, but there's an important parallel: In private financial markets, when an interest rate is stuck at zero, how completely a debt is honored becomes the natural margin on which terms adjust.