Editor’s note: We thank Professor Steven L. Schwarcz, the Stanley A. Star Professor of Law & Business at Duke University School of Law, for permission to publish an extended abstract of his paper, “Rollover Risk: Ideating a U.S. Debt Default,” forthcoming in the Boston College Law Review.
Although the U.S. government has technically defaulted on its debt in the past, his paper explains why such a default today would be much more devastating. Indeed, because almost half of U.S. debt is currently held by foreign investors, even the threat of a default could undermine the nation’s creditworthiness.
How could a U.S. debt default occur? How it could be avoided? What are its potential consequences if not avoided? And how could those consequences 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.
The classic view is that a national debt default—meaning a “hard” default on the debt, which includes non-payment of debt when due, ultimately depends on the country’s expenditures exceeding taxes and new borrowings.
That view, however, does not adequately differentiate between insolvency and illiquidity.
Insolvency occurs when total liabilities exceed the value of total assets, whereas illiquidity occurs when liquid assets (such as cash, short-term securities, and other assets readily convertible to cash) are insufficient to pay current liabilities as they become due.
It is possible for a nation to be solvent but illiquid, causing the nation to default on its debt.
We can assume that the United States is unlikely to become insolvent. Nonetheless there is a real risk of its illiquidity. The most cause of illiquidity is rollover risk: the government’s temporary inability 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.
There are different ways the U.S. government could avoid default, such as monetizing its debt and printing money to pay maturing debt. 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.
A U.S. debt default would also raise a host of legal issues, including questions of first impression under the 14th Amendment, which prohibits the government from questioning the “validity” of its public debt.
This provision was originally included in the Constitution to prevent a southern Democratic majority from repudiating Civil War debts. Despite the provision’s history, most believe—and in Perry v. United States, the Supreme Court concluded—that it applies generally, not just to Civil War debts.
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.
There are other negative consequences of how 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.
Steven L. Schwarcz, the Stanley A. Star Professor of Law & Business at Duke University School of Law, is the author of “Rollover Risk: Ideating a U.S. Debt Default.” His article is forthcoming in the Boston College Law Review, and full version is also available 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 Regulation.
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