A treasury default apocalypse?

It depends.

The press and pundits are inundating us with predictions of calamity if the debt ceiling is not raised by the approaching deadline. Dire predictions that a Treasury default in making an interest payment will lead to a collapse of the stock and bond markets are widespread, with visions of a plunging dollar leading to a major economic depression. Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke are in the chorus.

Even if it’s true that a failure to raise the debt limit in time to avoid a default would cause an immediate and large dive in the financial markets, the equally important question is what would be the effect if Congress does not act convincingly at this critical juncture to reduce our deficits?

Whether the debt limit is raised on time or delayed for a short period, the immediate effect would likely depend on whether investors, from Main Street to China, believed that Congress was about to quickly resolve the deficit problem and that a suspension of interest payments either would be over in a matter of days or that the Treasury could make some temporary financial rearrangements to enable it to continue paying interest for the very short period it would take for Congress to take remedial action. With this scenario, despite some serious selling, the projected collapse would not occur. Indeed, some would see it as a buying opportunity.

This is essentially the view of Stanley Druckenmiller, former fund manager for George Soros and considered one of the world’s most successful money managers. His view is that it would be irresponsible not to raise the debt limit, but far more irresponsible – and dangerous – to raise it beyond the present $14.3 trillion limit without solid controls to reduce the deficit.

The following example, adapted from an illustration by Mr. Druckenmiller, illustrates the point.

Say you own a ten-year Treasury bond promising cash flow over ten years. Congress doesn’t increase the debt ceiling and it becomes clear that your next interest payment is going to be delayed for a few days. It appears certain that your interest payment will be made after a short delay and it also appears clear that Congress is going to make massive cuts in entitlement spending and the government will shortly put its financial house in order. Now you’re confident that you can count on getting your missed interest payment shortly and undiminished interest and principal payments in the future. Under this scenario, you would probably figure it’s better to hold than sell.

Now assume a different scenario. The debt limit is raised so there is no delay in payments of interest, but Congress does not make the massive cuts in entitlement spending and take the other necessary steps to reduce the deficit, so it’s clear that Congress is going to kick the can down the road again, piling up trillions of dollars of additional debt. Now it looks like the only way you’ll get paid is with ever cheaper dollars printed in massive quantities by the government, driving inflation through the roof and driving the value of your bond into the basement as nominal interest rates soar. Wouldn’t you lose confidence in the continuing value of your bond? Isn’t it time to sell?

Confidence, that’s the key. When bondholders lose confidence, when they believe the government is going to monetize the debt, that’s when they start to sell.

There are already disquieting signs of diminishing confidence in the quality of Treasury bonds. Standard & Poor’s recently warned that the AAA status of Treasuries was no longer assured. Bill Gross of Pimco, the nation’s largest bond fund, recently sold its entire portfolio of Treasuries.

Decisions about the deficit and debt issues are now squarely before Congress and the country. If Congress fails at this critical watershed moment to take definitive steps to tame the deficit and debt, will Main Street and China lose confidence? If serious selling starts, it could become a torrent in hours.

If there’s no credible fiscal reform soon, in both spending reduction and revenue raising, heavy bond selling could begin, and that is how the financial apocalypse will start. If it starts and Congress does not quickly and convincingly slash the deficit, the bond selloff could turn into a deluge, brutally spiking interest rates upward and bond prices brutally down. Then, as in the 2008 financial crisis, short-term lending would dry up causing business to slow, creating a run on money market funds and panic in the stock market – as the recent meltdown demonstrated.

And this time the ability of government to stem the crisis is different. Last time Congress and the Fed stepped in with massive stimulus and injections of liquidity to stop the free fall in markets. Now such intervention on the scale required could actually be seen as trying to extinguish a fire with gasoline. The intervention would be viewed as compounding the inflation problem with a new flood of dollars pushing inflation up further. The recent run up of gold prices shows just how skittish many investors are about this possible scenario.

If Congress didn’t step in immediately with Draconian reforms to halt the downward spiral, the doomsday predictions of depression by the pundits could materialize – not because the debt limit was not raised, but because it was, but without deep fiscal reform.