What If the U.S. Treasury Defaults?

'People aren't going to wonder whether 20 years ago we delayed an interest payment for six days. They're going to wonder whether we got our house in order.'

By JAMES FREEMAN

'A financial crisis is surely going to happen as big or bigger than the one we had in 2008 if we continue to behave the way we're behaving," says Stanley Druckenmiller, the legendary investor and onetime fund manager for George Soros. Is this another warning from Wall Street that Congress must immediately raise the federal debt limit to prevent the end of civilization?

No—Mr. Druckenmiller has heard enough of such "clamor and hyperbole." The grave danger he sees is that politicians might give the government authority to borrow beyond the current limit of $14.3 trillion without any conditions to control spending.

One of the world's most successful money managers, the lanky, sandy-haired Mr. Druckenmiller is so concerned about the government's ability to pay for its future obligations that he's willing to accept a temporary delay in the interest payments he's owed on his U.S. Treasury bonds—if the result is a Washington deal to restrain runaway entitlement costs.

"I think technical default would be horrible," he says from the 24th floor of his midtown Manhattan office, "but I don't think it's going to be the end of the world. It's not going to be catastrophic. What's going to be catastrophic is if we don't solve the real problem," meaning Washington's spending addiction.
Widely credited with orchestrating Mr. Soros's successful shorting of the British pound in 1992, Mr. Druckenmiller also built his own fund, Duquesne Capital, into a $12 billion titan. He announced plans last year to close the fund and now reports, "I have no clients." He is still managing his own money, which Forbes magazine recently estimated at $2.5 billion.

Whatever the correct figure is, it would be significantly larger if Mr. Druckenmiller hadn't given away so much of his wealth. The online magazine Slate reported last year that Mr. Druckenmiller and his wife gave away more money in 2009—over $700 million—than anyone else in the country. Over the last two decades, he has been the largest benefactor of the Harlem Children's Zone, a community service organization featured in the movie, "Waiting for 'Superman.'"
It's hard to think of someone with more expertise in the currency and government-debt markets, but Mr. Druckenmiller's view on the debt limit bumps up against virtually the entire Wall Street-Washington financial establishment. A recent note on behalf of giant banks on the Treasury Borrowing Advisory Committee warned of a "severe and long-lasting impact" if the debt limit is not raised immediately. The letter compared the resulting chaos to the failure of Fannie Mae and Freddie Mac and warned of a run on money-market funds. This week more than 60 trade associations, representing virtually all of American big business, forecast "a massive spike in borrowing costs."

On Thursday Federal Reserve Chairman Ben Bernanke raised the specter of a market crisis similar to the one that followed the 2008 bankruptcy of Lehman Brothers. As usual, the most aggressive predictor of doom in the absence of increased government spending has been Treasury Secretary Timothy Geithner. In a May 2 letter to House Speaker John Boehner, Mr. Geithner warned of "a catastrophic economic impact" and said, "Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover."

In a Monday speech at the New York Economic Club, Mr. Boehner fired back, saying that "It's true that allowing America to default would be irresponsible. But it would be more irresponsible to raise the debt ceiling without simultaneously taking dramatic steps to reduce spending and reform the budget process."

So the moment couldn't be better to consult Mr. Druckenmiller, who almost never gives interviews but is willing to speak up now because he thinks that fears about using the debt-limit as a bargaining chip for spending cuts are overblown—and misunderstand the bond market. "The Treasury borrowing committee letter speaks about catastrophic financial crises, comparing it to Fannie and Freddie. That's not what we're talking about here," he says.

He contemplates the possibilities for bond investors if a drawn-out negotiation in Washington creates a short-term problem in servicing the debt but ultimately reduces spending:

"Here are your two options: piece of paper number one—let's just call it a 10-year Treasury. So I own this piece of paper. I get an income stream obviously over 10 years . . . and one of my interest payments is going to be delayed, I don't know, six days, eight days, 15 days, but I know I'm going to get it. There's not a doubt in my mind that it's not going to pay, but it's going to be delayed. But in exchange for that, let's suppose I know I'm going to get massive cuts in entitlements and the government is going to get their house in order so my payments seven, eight, nine, 10 years out are much more assured," he says.


Then there's "piece of paper number two," he says, under a scenario in which the debt limit is quickly raised to avoid any possible disruption in payments. "I don't have to wait six, eight, or 10 days for one of my many payments over 10 years. I get it on time. But we're going to continue to pile up trillions of dollars of debt and I may have a Greek situation on my hands in six or seven years. Now as an owner, which piece of paper do I want to own? To me it's a no-brainer. It's piece of paper number one."

Mr. Druckenmiller says that markets know the difference between a default in which a country will not repay its debts and a technical default, in which investors may have to wait a short period for a particular interest payment. Under the second scenario, he doubts that investors such as the Chinese government would sell their Treasury debt and take losses on the way out—"because I'll guarantee you people like me will buy it immediately."

Now suppose, Mr. Druckenmiller adds, that he's wrong. If the market implodes on day two of the technical default, Mr. Obama and Congress would be motivated to finally come to agreement. But he doesn't expect such market chaos. "My guess is that the bond market would rally as long as it believed the ultimate outcome was going to be genuine entitlement reform—that we wouldn't even have to find out about a meltdown because it wouldn't happen. And I have some history on my side here."

And the scars to prove it. In 1995, Bill Clinton was threatening to veto budget cuts advanced by the Republican House. In return, congressional leaders threatened not to increase the federal debt ceiling. Back then, before Americans knew what a real government spending crisis was, the debt stood at less than $5 trillion. (It has nearly tripled since then and is poised to race some $10 trillion higher in the next decade.)

Mr. Druckenmiller had already recognized that the government had embarked on a long-term march to financial ruin. So he publicly opposed the hysterical warnings from financial eminences, similar to those we hear today. He recalls that then-Secretary of the Treasury Robert Rubin warned that if the political stand-off forced the government to delay a debt payment, the Treasury bond market would be impaired for 20 years.

"Excuse me? Russia had a real default and two or three years later they had all-time low interest rates," says Mr. Druckenmiller. In the future, he says, "People aren't going to wonder whether 20 years ago we delayed an interest payment for six days. They're going to wonder whether we got our house in order."

Mr. Druckenmiller notes that from the time he started saying that markets would welcome a technical default in exchange for fundamental reform, in September 1995, "the bond market rallied throughout the period of the so-called train wreck . . . and, by the way, continued to rally. Interest rates went down the whole time, past the government-shutdown deadline, and really interest rates never went back up again until the Republicans caved and . . . supposedly the catastrophic problem was solved."

He adds, "I owned [Treasury] bonds and Rubin accused me and Soros of being short them, and that this was some sort of conspiracy. We made a fortune being long bonds during the whole fight. We were advocating a default and we were long bonds. That's kind of putting your money where your mouth is. By the way, I'm long them today."

Mr. Druckenmiller is puzzled that so many financial commentators see the possible failure to raise the debt ceiling as more serious than the possibility that the government will accumulate too much debt. "I'm just flabbergasted that we're getting all this commentary about catastrophic consequences, including from the chairman of the Federal Reserve, about this situation but none of these guys bothered to write letters or whatever about the real situation which is we're piling up trillions of dollars of debt."

He's particularly puzzled that Mr. Geithner and others keep arguing that spending shouldn't be cut, and yet the White House has ruled out reform of future entitlement liabilities—the one spending category Mr. Druckenmiller says you can cut without any near-term impact on the economy.

One reason Mr. Druckenmiller says he spoke up in 1995 was his recognition that the first baby boomers would turn 65 in 2010, so taxpayers would soon have to start supporting a much larger population of retirees. "Well," he says today, "the last time I checked, it's 2011. We don't have another 16 years this time. We're there. I don't know whether the markets give us three years or four years or five years, but we're there. We're not going to be having this conversation in 16 years. We're either going to solve it or we're going to find ourselves being Greece somewhere down the road."

Some have argued that since investors are still willing to lend to the Treasury at very low rates, the government's financial future can't really be that bad. "Complete nonsense," Mr. Druckenmiller responds. "It's not a free market. It's not a clean market." The Federal Reserve is doing much of the buying of Treasury bonds lately through its "quantitative easing" (QE) program, he points out. "The market isn't saying anything about the future. It's saying there's a phony buyer of $19 billion of Treasurys a week."

Warming to the topic, he asks, "When do you generally get action from governments? When their bond market blows up." But that isn't happening now, he says, because the Fed is "aiding and abetting" the politicians' "reckless behavior."

And they could get even more reckless. Mr. Druckenmiller acknowledged by 1996 that the Republican budget shutdown strategy had failed, and he agrees today that the worst outcome would be a technical default that still doesn't muster enough pressure to force the Beltway to change its spending habits. This possibility "scares the hell out of me because I don't know whether Obama would cave. I tell you one thing, if [Obama officials] believe what they're saying, they'll cave. If they believe this is Armageddon and this is worse than Lehman and this is the greatest catastrophe ever, they'll cave."

But what if Mr. Obama hangs tough, Republicans cave, and there is no spending reform between now and the 2012 elections? Would Mr. Druckenmiller sell his Treasurys? "Everything else being equal, that would be a big sell factor, not a buy factor. One of the reasons I bought the Treasurys a ways back was I thought [House Budget Chairman Paul] Ryan was serious. I mean I heard some serious things that I hadn't heard in a long time." When President Obama responded to Mr. Ryan with a harsh partisan attack instead of a serious policy proposal, "that made me feel not as good about my Treasurys as the day before. But I'm still long them," he says.


Mr. Druckenmiller says he's "a registered independent" but says he admires New Jersey Gov. Chris Christie for the way he has explained that the state has to reform its benefit plans if it is going to be able to take care of retired government workers. He argues that the same case needs to be made nationally. "We don't have a choice between Paul Ryan's plan and the current plan, because the current plan is a mirage. . . . That money is not going to be there."

Given Mr. Druckenmiller's track record, officials at the Fed and Treasury may not have a choice, either. They may finally have to try to explain why technical default is a crisis, but runaway spending is not.

Mr. Freeman is assistant editor of The Journal's editorial page.