With the platinum coin dead, the small probability that the United States will default on its debt or other obligations has ticked up significantly. While some commentators say default won’t happen because it’s illegal, and therefore the possibility and potential consequences are not even worth considering, I think we should absolutely study the effects of default on the economy, the financial markets, and Treasury yields. I tend to think that in the short term, the panic caused by default will actually cause yields to fall as investors buy safe (!) Treasury bonds, but let’s look at the last time the United States defaulted on its debt.
That happened in 1979 and the event is the subject of an article by finance professors Terry Zivney and Richard Marcus. The Treasury was unable to pay Treasury bills maturing on April 26, 1979, May 3, and May 10, 1979 (emphasis added):
The Treasury blamed the delay on an unprecedented volume of participation by small investors, on the failure to Congress to act in a timely fashion on the debt ceiling legislation in April, and on an unanticipated failure of word processing equipment used to prepare check schedules. Though these conditions were temporary, in truth—this was the day the United States defaulted.
The United States defaulted on a total of $122 million in T-bills. Based on prevailing interest rates at the time, the holders of those T-bills lost $325,000 in interest, and some of the investors filed suit in federal court in California. The Treasury pointed to Smyth v. United States, a 1937 Supreme Court decision which held that “interest does not run upon claims against the Government even though there has been a default in the payment of principal,” but decided to offer compensation anyway.
The authors looked at what happened to yields on T-bills in the period after the default. They conclude that while there was also a flight to quality in the weeks after default, the default did have a lasting effect on yields:
Although causality cannot be established with only one observation—the sole instance of a U.S. T-bill default—a careful review of the Wall Street Journal failed to uncover a better explanation for the sudden surge in interest rates. Under the guiding principle that one good explanation is better than twelve weak ones, we therefore conclude that the series of defaults resulted in a permanent increase in interest rates of about 60 basis points.
Federal debt held by the public was about $630 billion at the time (but increasing), so if the authors are correct and the increase in Treasury yields applied to all debt, the episode could have cost taxpayers more than $3 billion a year in extra interest cost.