As congress fails to agree on a plan to increase government's borrowing limit, chances of US government defaulting are increasing everyday. Everyone is saying that it is going to be catastrophic. Paul Krugman said if it happens then it is going to be "1937 squared". Although market's are down but they have not collapsed and that's because market still believes the probability of default is low. So market is currently multiplying the probability of default to the impact of default and calculating new prices. Now this probability increases everyday bringing market's down slowly. When and if US government defaults, we'll see the impact because then this probability will be 100 percent.
Like most people who love Economics I have been thinking about the potential impact. So let's start from scratch. When US government defaults, its credit rating will go down. This means any future borrowing will be expensive. There are institutions who are required to hold only AAA rated bonds for their investments. They will have to sell US treasury bonds to buy other AAA rated securities. This will derive the the prices of AAA securities up and reduce their current yield. This means that institution who are required to hold AAA securities will make less money. How are they going to respond? That's a difficult question but just hope that some genius does not come out with something like "mortgage back securities" and hope that rating agencies don't assign it AAA ratings. That being said, if US government defaults, vendors will not be able to get the money. It will also reduce its spending which in turn means that several companies who rely on US government as a major customer will be at risk. Stock prices for such companies will go down due to expected lower earnings and it will create a ripple effect tanking the stock market and economy. Investors will buy gold since US dollar is no more a safe haven and we'll see a rise in already overly priced gold.
Like most people who love Economics I have been thinking about the potential impact. So let's start from scratch. When US government defaults, its credit rating will go down. This means any future borrowing will be expensive. There are institutions who are required to hold only AAA rated bonds for their investments. They will have to sell US treasury bonds to buy other AAA rated securities. This will derive the the prices of AAA securities up and reduce their current yield. This means that institution who are required to hold AAA securities will make less money. How are they going to respond? That's a difficult question but just hope that some genius does not come out with something like "mortgage back securities" and hope that rating agencies don't assign it AAA ratings. That being said, if US government defaults, vendors will not be able to get the money. It will also reduce its spending which in turn means that several companies who rely on US government as a major customer will be at risk. Stock prices for such companies will go down due to expected lower earnings and it will create a ripple effect tanking the stock market and economy. Investors will buy gold since US dollar is no more a safe haven and we'll see a rise in already overly priced gold.
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