Failing to raise the debt limit

July 10, 2011 9:40 AM

What happens if the U.S. defaults?

I know the scenario of an actual U.S. default is extremely unlikely. I am aware that realistically, the political game being played right now is theater, and the question really isn't "will we fail to raise the debt ceiling", but rather "by how much will we raise the limit, and with what conditions attached?" Nonetheless, the threat of a government default is interesting to me from a hypothetical standpoint, and I am curious:

What happens if the U.S. fails to raise the debt limit, and defaults on its obligations? (Not a technical default, where we eventually pay back everything we owe, but a real, live, "we're not paying our creditors" default.)

I am not looking for general answers like "it would be a terrible, unparalleled financial crisis." I recognize the severity of such a situation. I am wondering what the process would be: how and why would the economy begin to collapse? What are the consequences of supposedly risk-free treasury obligations losing all their value? How would this translate into problems for the broader economy? I am especially interested in hearing from people with a working knowledge of finance and economics.

I'd also be interested in literature on this subject. Are their any historical parallels that have been studied? (A sovereign default by a nation central to a global economy? My guess is no?) Academic papers written about this hypothetical?

posted by HabeasCorpus to law & government (13 answers total)

There have been sovereign defaults before, but none by a country as large as the United States. If you do a Google search for "sovereign default" you will find a number of academic papers which review the history of sovereign default.
posted by dfriedman at 9:43 AM on July 10, 2011

Thanks. I should clarify that I've done the google thing, but I'm not particularly knowledgeable about the scholarly state of economics. I guess I should have been more specific: who is considered a well-regarded authority about this in the field? Are their any works, books, theories, etc. that are considered particularly noteworthy?
posted by HabeasCorpus at 9:47 AM on July 10, 2011

Essentially the interest rate that the US would have to offer people who are buying debt would increase to compensate the additional risk that it would not be paying off the debt. Traditionally, US debt interest has been very low, keeping the percentage of our taxes that we pay going to make these interest payments also very low. So the cost of creating debt for our government would increase, meaning there is less bang for the buck in debt creation.
posted by msbutah at 9:56 AM on July 10, 2011

The US dollar could lose a lot of its value vis-a-vis other currencies. Actually this is already happening, in a slow way. The Canadian dollar has gained maybe $.20 against the US one over the past year, and other currencies have gone up against it similarly. The danger with something like a default is that there could be an extreme loss of confidence in the USD. I don't think it's very likely, because I think these things are a bit stage-managed, as you say. But possible.

When a currency loses value, imports become more expensive. The US imports a lot of things, so that would be a serious issue. I imagine oil prices would go up, for example.

Changes have to happen anyway, but it's a question of how abruptly they happen.

Paul Kennedy's "The Rise and Fall of Great Powers" is a pretty standard historical analysis of things like this.
posted by Net Prophet at 10:03 AM on July 10, 2011

Well, you can see a little bit of what might happen by looking at a previous 'accidental' default from 1979.
posted by empath at 10:33 AM on July 10, 2011

All my strictly personal thoughts...

A real default could feed on itself. If we didn't pay a little of our debt, interest rates would rise so quickly we couldn't pay the rest, because refinancing paper would bear interest that would exceed plausible tax collections.

The US would likely have to introduce price and wage controls to stop a devaluation/interest rate hyperinflation cycle. Many companies and governments and possibly most financial instituions would become insolvent as their "cash equivalent" short term treasuries lost 20% or more of their value.

Exporters to the US would choose between dramatic hikes in the dollar costs of their goods or dramatic cuts in the local currency price they accept.

Exporters from the US would experience a windfall like no other (if they don't have a lot of t-bills). They will massively increase dollar profit with which they can buy US assets and retire sold-off dollar debt. They will also retake US share from importers who don't elect to cut their local-currency-equivalent dollar prices.
posted by MattD at 10:37 AM on July 10, 2011 [1 favorite]

MattD: "Exporters from the US would experience a windfall like no other"

The caveat I'd want to add to that is that there are costs of adjustment. We're talking about switching an economy over from importing much more than it exports, to the reverse. Huge adjustments like that have costs associated with them, and they don't happen overnight. Yes a weaker currency means that the US can export more cheaply, but to take advantage of that requires building new factories to produce stuff, training work forces, and designing competitive products to export.

I think adjustment costs are really neglected in economics literature, because they don't support free-market ideology very well. One book I know of which goes into the concept is International Monetary Power
posted by Net Prophet at 12:50 PM on July 10, 2011

This is kind of what happened in Illinois. They "balanced" their budget by simply not paying bills on time.

Based on some of the things I've heard Tim Geithner saying, this might be what the Treasury is already doing. Because they are scraping up against the debt limit, they have cash flow issues. So, important bills get paid so as not to default, but less important bills get pushed back.

Like in IL or your own checking account, this starts to snowball. Demands get met, but there looms an ever greater backlog of things that you just don't have the ready cash to pay.

What will happen in the short term is that the debt will get paid. The US won't technically default on bonds and so forth. But they will start late-paying anyone they can. This can go on for a while, until their sub contractors and employees start getting affected. THEN there will be political will to raise the debt ceiling. Meanwhile, the credit rating agencies will lower their estimation of the US's ability to pay back because they see that political gamesmanship trumps financial obligations.
posted by gjc at 1:02 PM on July 10, 2011

Treasury Secretary Tim Geithner was out on the US Sunday TV talk shows, hawking the August 2 date as catastrophic (but avoidable, and expected to be avoided by prompt Congressional action), but in his usual doublespeak fashion, did a poor job of explaining why an August 2 technical default is such a big deal to the U.S. economy. The problem we're facing in August isn't just the $135 billion or so of net new borrowing we need to do, to allow the government to keep spending at current rates, with tax revenues coming in at their current low rates, it's that we have to rollover about $500 billion of old debt due in August, to new debt, to keep the shell game going.

It's the rollover timing that really makes this a problem, as we first have to borrow about $510 billion new dollars, before we can "pay off" the $500 billion in existing debt we owe that comes to maturity in August, and so, for a couple weeks, we'd be way beyond the current debt ceiling authorization. Back in May, when raising the debt ceiling was first being discussed as part of usual U.S. government finance action, we had enough time to have perhaps done something else about managing our debt, had we taken drastic actions to keep some "headroom" under the current limit. But now, in a game of political "chicken," the current Administration has kept spending all summer, expecting Congress to raise the debt ceiling when forced to by the threat of a technical default in August, and to adopt additional measure to raise tax revenue.

But outside the $500 billion old debt rollover issue, gjc has it right - a technical default wouldn't mean the U.S. would cease to pay all its obligations, it would just have to take some drastic actions to cut spending quickly (government layoffs, entitlement payment stretch outs, state revenue sharing payment delays, procurement contract cancellations, etc.) raise additional cash flow where possible (going after delinquent tax payments, raising user fees on government services, selling government assets, selling oil leases, selling arms to foreign governments, etc.), and prioritize that cash flow to debt service. It would be many months before any foreign lenders or domestic holders of Treasury notes or bonds stood in jeopardy of taking actual losses on such instruments. In the meantime, interest rates on U.S. Treasury instruments would go up, in direct proportion to how the world perceived extraordinary possible actions like the Federal Reserve buying Treasury debt (basically printing new dollars to directly lend to the Treasury to pay old debt and new obligations - which would be seen as highly inflationary, by the rest of the world), and any continuing efforts by the Congress and Administration to return to orderly debt issuance under new authorizations.
posted by paulsc at 1:51 PM on July 10, 2011

BTW, if you want to see who is due how much, and when on "current" accounts in August, and play Tim Geithner's role in choosing who gets paid and who doesn't in a hypothetical post-August 2 default scenario, have a look at the BiPartisanPolicy.org Debt Ceiling Analysis presentation, where they've broken out, day by day, for the rest of August, the expected revenue of the U.S. government, against obligations to pay, short of the $500 billion roll over problem. It's not pretty, but it's nowhere near the international panic level that a default on the $500 billion of old debt rolloever would cause...
posted by paulsc at 3:42 PM on July 10, 2011

This is kind of an impossible question to answer because there is no rational reason the US would ever default.

The US borrows money in dollars, and also controls the production of dollars. If tax receipts ever got so low that the government couldn't cover interest payments on the debt, it could always inflate the currency in order to reduce the amount it has to pay back. Inflation is uncomfortable and messy, but it's vastly preferable to a default.

Any default that does happen is the result of our dysfunctional political system. How bad the default is depends on exactly how dysfunctional our political system is, and how long it stays that way. It's very hard to predict what will happen in a scenario that involves so many hypotheticals.
posted by miyabo at 4:33 PM on July 10, 2011

Some decent content here but what hasn't been touched upon is the impact on credit markets (global +80trn not counting notional exposure). T bills are the gold standard for all AAA debt instruments in the world. Institutions from banks to pension funds have mandates for the qualitative structure of their holdings (e.g. A pension fund must have x% of it's assets in AAA bonds). A credit downgrade of us debt precipitated by a technical default would lead to a chaotic frenzy in global debt markets, as the stability of institutional assets could be greatly stressed if yields rise precipitously(plunging their face value). It theoretically could have a cascade effect where the notes are dumped broadly in an opaque/distressed situation. That damage feeds into the loop of global equity markets as well as the broader economy much the same way we saw things post Lehman 08. It is impossible to accurately gauge the pervasiveness or direction of these events given the infinite complexity behind the networks of financial systems but the degree of chaos lends one to believe that the damage is measurable. I've personally paired back equity holdings given the macro uncertainty via this issue, Greek foreign debt and Chinese credit constriction. I am not your financial advisor and this post is sheerly academic.
posted by Hurst at 4:35 PM on July 10, 2011

The real problem with an american default is that it's a black swan. Hedge funds basically work by figuring out all the risks involved in a position and betting both sides -- like betting red and black and roulette. For example, they buy a mortgage, and they buy insurance on the mortgage in case it defaults. No matter what happens, assuming that they've properly accounted for all the possibilities and assigned probabilites to all of them correctly, they'll eke out a small profit. They turn that small profit into a huge profit by borrowing huge piles of money and piling it into all of their investments, so instead of earning 2% on a million dollars, they earn 1% (after interest) on 10 million dollars or a 100 million dollars, or whatever.

The problem is that most of these hedge funds have assigned the probability of a US default at as close to 0% as it's possible to be. When that number goes from 0% to 100% chance of default, it throws the entire economic system out of wack. All of the assumptions that everyone has been making go out the window. Insurance companies providing credit default swaps would go under, hedge funds would collapse, sovereign wealth funds heavily invested in t-bills (a lot of them) might go under, taking down governments and so on.

It would destroy the world economic system, and probably plunge it into depression. It would be many times worse than Long Term Capital Management, which collapsed of the Russian and East Asian financial crises.
posted by empath at 8:54 PM on July 10, 2011