Abacus: Say the U.S. Defaults?

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Our Government flew past the legal U.S. Debt Ceiling fairly quietly about a month and a half ago. In the midst of a million other headlines and “executive” scandals, the significance of this action has been largely underplayed. As Secretary of the Treasury says in a letter to the Speaker of the House on March 16th, “I respectfully urge Congress to protect the full faith and credit of the United States by acting to increase the statutory debt limit as soon as possible.”

The initial need for the letter is to inform Congress of the Fed’s use of “Extraordinary Measures.” Basically, the Treasury Department can suspend investments in three separate funds in order to provide them with extra short term cash to continue government operations without borrowing more cash. These funds being: 1) The savings plan for federal employees (known as the G Fund), 2) the Exchange Stabilization Fund, used for the government’s currency operations, and 3) the Civil Service Retirement and Disability Fund, the main pension fund for federal workers.

By employing these extraordinary measures, we estimate that congress won’t have to reassess the debt limit situation until back-to-school season. For those unaware of what our debt limit situation is: The United States Debt Cleaning was implemented during World War I as a way for congress to exert influence on spending and debt issuance, while still letting the Treasury run the show. In layman’s terms, it’s the congress-approved maximum amount of debt the U.S. Government can have before we are legally required to stop borrowing money and issuing debt (Treasury bonds, securities, et cetera.) At this point, we’d basically have to stop running a deficit and start paying our bills down for once. Currently, the U.S. Debt ceiling stands at $19.9 Trillion, and has been permanently raised, extended, or redefined 78 times in total. Since this ceiling was put into place, it has been “rapidly raised with little fuss,” until the 21st century financial crisis. Below is our total public debt-to-GDP ratio since 1966 (check out the interactive graph here.)

Source- Federal Reserve Economic Data

Source- Federal Reserve Economic Data

Now that total public debt has reached 105% of our GDP, and since the economic crash in 2008, U.S. public debt has become more of a bi-partisan debate point; i.e. raising it is no longer a non-issue, on either side of the aisle. For instance, Congress came so close to breaching the ceiling in 2011, that Obama even prepared a speech in case the U.S. partially defaulted on its debt.

Now that the debt limit has become more of a political issue than purely economic (and therefore more likely), I want to explore the economic implications of, first, rupturing the ceiling, and then secondly, the economic apocalypse that would come from the U.S. defaulting on its debt.

A United States debt-default would basically be a chain reaction stemming from a loss of faith and credit in the United States, as referenced at the beginning of this column. Imagine you can’t pay your student loans off, and then you have to file for Chapter 7 bankruptcy. You lose all your money and possessions probably, or maybe just collateral, but mostly, you lose your credit rating. Meaning that you have lost any faith creditors initially had in you. On a micro-scale, this means you won’t be able to buy that new Ford Focus you want, or get a mortgage to fund your dream of becoming a homeowner, et cetera.

In the most basic sense, this is somewhat similar to the U.S. Government, they would lose the ability to fund the projects they want/need to. “The choices it will face quickly become stark”, as the Government starts to default on debt obligations, and will begin to pick and choose between paying interest on debt, social security checks, and the millions of other payments they promised to individuals, corporations, and other governments. While that happens, most or all of the government programs will shut down; the FBI goes down, the prisons will stop operating, Yosemite Park will close its doors, so on and so forth.

Furthermore, major credit-rating agencies worldwide would seriously downgrade the United States credit rating; i.e. loss of faith and credit in our Nation’s government. Similar to how you wouldn’t be able to borrow money at the same pre-bankruptcy rates, it would become way costlier for the U.S. to both borrow money and issue debt obligations. The key issue that sparks a worldwide chain-reaction of economic crisis is the fact that U.S. Dollar is considered the world’s “reserve currency”. In which U.S. Treasuries represent both the benchmark borrowing rate for all other bonds, and the risk-free benchmark to value all other worldwide securities with inherent risk. Since investors would now require a higher return on U.S. debt obligations (due to higher risk on a lower credit rating), interest rates would rise worldwide, making it more expensive for corporations, consumers, and other governments to borrow and invest. Spiked interest rates would spike inflation, causing the value of our Dollar to substantially drop. Additionally, all stock indexes would plummet, as investors either flee to other countries for investments, or move all their money into gold (which would also spike the price of gold.)

Finally, in terms of U.S. Dollar-denominated bonds, 1) many emerging economies issue them to raise money to finance obligations, and undermining the trust in these bonds could seriously devalue them. 2) The U.S. Treasury Market is pretty much the deepest and most liquid in the world, allowing investors to exchange government-issued securities for cold hard cash in secondary markets really easily, no matter the economic circumstances. If the Government were to start defaulting on these, or stop paying interest payments, the value of U.S. Treasuries on this secondary market would plummet. This would send the market into a liquidity and price spiral, as anyone attempting to sell their Treasury would have to deeply discount it, and then probably couldn’t sell it anyways.

The overall result from Trump’s congress not unilaterally raising the debt limit: Worldwide economic catastrophe. Check out the Treasury Report on the impact from a potential default:

"In the event that a debt limit impasse were to lead to a default, it could have a catastrophic effect on not just financial markets but also on job creation, consumer spending and economic growth — with many private-sector analysts believing that it would lead to events of the magnitude of late 2008 or worse, and the result then was a recession more severe than any seen since the Great Depression."

Due to the gravity of this potential incidence, expect the House and Senate to push the debt ceiling further upwards come November or October. The next question for our government is, when do we start cutting our public debt?