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What happens if the US defaults?

Having a former Merrill Lynch boss caution against irresponsibility is somewhat akin to hearing Beyonce’s choreographer laying into excessively raunchy dance routines. But Richard Bernstein, once chief investment strategist at the collapsed investment bank, is sincerely convinced that the US should not go into technical default.

Yet that is just what could happen in early August, if some Republicans have their way. In layman’s terms, the planet’s largest economy has already maxed out its credit card limit, which is $14.3 trillion. Unless Congress lets it go higher, the US Treasury will run out of cash and be forced to delay bond interest payments.

Oh, and some 55m Americans might not get their monthly social security cheque, although that is not really what is bothering the markets.

In the normal run of affairs, upping the threshold would be a formality; after all, the ceiling has been increased 74 times since 1962. Trouble is, this time round the GOP is being obstructionist about it, so it’s no dice unless the administration agrees to $2 trillion in public spending cuts and guarantees no tax hikes.

Don’t even go there, Bernstein warns:

The notion of flirting with default is absolutely amazing to me,” he said. “A default will place a burden on future generations. The cost of capital throughout the United States will go up. That hurts mortgages, that hurts corporations, that hurts individuals. I don’t get it.”

Let me run that past you slowly. What is left of Merrill Lynch – now part of Bank of America – was last month fined $3m for lying to investors about the subprime mortgage securities the sold in the mid-noughties. This was on Bernstein’s watch; all of a sudden the guy is opposed on principle to anything that ‘hurts mortgages, hurts individuals’

Of course, only a cynic would suggest that that Bernstein, who now runs his own capital management outfit, is somewhat more concerned with the impact on Wall Street than on how it all pans out for Joe Six Pack.

Yet despite the suspect provenance of the admonition, Bernstein is almost certainly correct. I say ‘almost certainly’ because we have never been here before and therefore nobody knows for sure what happens next. But the likelihood is that even if default is short-lived, the consequences will be enormous, and felt everywhere.

US bonds are supposedly the closest it gets to risk-free investment. Ratings agency Fitch has already warned that failure to raise the debt limit could mean the loss of triple A credit standing, and might even see some T-bills get relegated to ‘junk’ status.  That alone would cause bond prices to fall sharply, and yields on the debt to go sky high.

Among those invested in US sovereign debt are money market funds, which will come under strain as retail investors rush for the exit. These institutions are, in turn, important providers of liquidity for major banks. The scenario would be a re-run of September 2008.

More expensive mortgages and credit would further undermine consumer confidence and thus take aggregate demand out of the US economy at a time when aggregate demand is exactly what it needs.

Prospects such as this would be hairy enough in normal times. But as those watching events unfold in Greece will testify, these are not normal times. In the name of neoliberal dogma, around two dozen senators on the irresponsible right are playing chicken with the world economy.

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