Marginal Revolution gives basic scenario of the default

Interest rates skyrocket and there are numerous collateral calls from clearinghouses and thus a squeeze on Treasuries. Everyone is scrambling after Treasuries and suddenly T-Bill liquidity is quite scarce. (Here is one FT post on collateral crunch.) The next morning retail runs on money market funds commence and most redemptions cannot be made (another FT post here). Those funds are shuttered and new commercial paper issues are put on hold.

By mid-morning of the 17th the payments system has shut down entirely. The Fed tries everything possible, but even with a flood of monetary liquidity, T-Bills are “not what they used to be” and no flow of reserves can make up for this. The monetary authority cannot become the fiscal authority in the span of an hour or a day, especially when it doesn’t have a fully credible fiscal authority behind it. The payments system remains gridlocked. Elsewhere, the Italian 10-year rate shoots over eleven percent, so the ECB has to invoke Outright Monetary Transactions, but the Germans get nervous and don’t go whole hog with this program. A lot of European credit markets shut down too.

Lots of countries have defaulted on debt.  Sometimes the debt owners take a haircut, more often they just have to wait.  In the United States there doesn’t appear to be danger of haircut, just of delays.  But the delay in payments could be very costly.  Much of the financial system relies on highly leveraged transactions being cleared every day.  A medium sized stone tossed carelessly in the pond might generate huge ripples.

via Marginal Revolution — Small steps toward a much better world..

About mkevane

Economist at Santa Clara University and Director of Friends of African Village Libraries.
This entry was posted in United States. Bookmark the permalink.