Eliminating the Debt Ceiling Wouldn’t Cause Interest Rates to Surge

I just read this at Euro Pacific Capital, Peter Schiff’s company.  He says we should eliminate the debt ceiling so our creditors can cut us off:

“Such a development may be the shock therapy our creditors need to finally cut us off for good. If that occurs, interest rates in the United States could finally rise to more rational levels. A significant increase in the cost of borrowing will create the mother of all fiscal cliffs. It’s too bad that Tim Geithner can’t see that one coming.”

This is not correct.  Schiff misunderstands the design of our monetary system.  Our monetary system is designed in such a manner that the government harnesses the banks as funding agents.  Since Primary Dealers are required to bid at Treasury auctions there is no concern over Dealers showing up to place bids and make “reasonable markets” in US government bonds.  The  NY Fed mandates this and ensures that they get kicked out of the club if they don’t comply.   (This doesn’t mean inflation couldn’t result in currency and bond rejection!).

And interest rates on government bonds are a function of Fed policy (which is a function of economic expectations), not what these banks are willing to pay for the bonds (again, they must make reasonable markets in government bonds as mandated by the Fed).  So, long rates are a function of short rates which are a function of the Fed’s future economic expectations.  If inflation worries were really high the Fed would raise short rates and long rates would surge (long bonds would tank as the traders would likely anticipate the change in policy).  The Fed chases economic performance (yes, at times making bad predictions) and the banks front-run the Fed.  That’s how fixed income traders work.  Obviously, Schiff doesn’t understand the trading dynamics at work here nor does he understand the monetary dynamics.

It’s that simple.  There will be no comeuppance in yields if the government eliminated the debt ceiling and the Fed kept rates at zero due to low inflation fears.  Just like the market wasn’t worried about QE2 ending (and all the persistent fear mongering about rates surging) or the S&P downgrade or the debt ceiling debates last year.  Yields remained low through all of these supposedly disastrous events.  We’ve literally heard this same prediction based on the same false understanding time and time again.