NEW YORK (MainStreet) — Just as Washington managed to avoid a government shutdown over the budget, we start hearing dire warnings about the tug of war over the debt limit: If it’s not raised, it will be Armageddon.
But in fact, a failure to resolve the debt-limit debate could indeed be very bad for all of us, undermining bond values, driving up borrowing costs and probably stunting the economic recovery.
In a nutshell, here’s what’s happening: The government spends more than it takes in from taxes and makes it up by borrowing, which is done by selling bonds. Every year the government sells new bonds to pay the principal due on older bonds that mature, like a consumer shifting debt from one credit card to another.
Congress makes this possible by routinely raising the debt limit, currently at $14.3 trillion. If it didn’t, something would have to give. Most likely the government would default, or stop paying interest or principal on some of the bonds it had sold in the past.
But isn’t that just a risk investors knowingly take when they buy bonds?
Technically yes, but U.S. government bonds have long been a kind of gold standard for safety, since the government, unlike corporations that issue bonds, never defaults. Because the bonds are considered safe, investors do not demand high interest earnings to compensate for risk, so the government can borrow at relatively low rates, which is good for taxpayers.
But if the risk of a government default rises, investors would demand higher yields. Currently, the 10-year Treasury bond yields about 3.6%, or $36 a year for a $1,000 bond. If newer bonds paid twice as much because of greater default risk, investors might pay only $500 for an older bond, so that $36 would equal 7.2% of the bond’s price. It’s actually a bit more complicated, but that’s generally why a rise in interest rates causes older bonds to fall in price.