We haven’t seen anything yet. If the government shutdown made a small splash in the economic world, the looming debt crisis has the potential to be a tsunami. Treasury Secretary Jack Lew has predicted October 17th, exactly two weeks from now, as the date we’re expected to breach the debt ceiling. While this scenario is far from a guarantee, recent developments in Washington, including Speaker Boehner’s continued ability to hold out on calls for him to break the Hastert rule and allow for a “clean” continuing resolution and a debt agreement to pass with a majority of Democratic votes, it now seems reasonable to assume that Congress and the President may fail to reach an agreement on raising the debt ceiling before it’s breached. Therefore, it’s worth examining what will happen if a deal isn’t reached and the United States defaults on its debt for the first time in our nation’s history.
Economists, politicians, pundits, and bloggers have been rather vocal in stating the catastrophic effects of a debt ceiling breach with Treasury Secretary Jack Lew announcing in a report today that breaching the debt ceiling has the potential to be “catastrophic: credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse”. How true are these claims? How much of these statements are merely political rhetoric and how much is rooted in a sound understanding of economics? There is no easy way to determine that since there is no perfect comparison; the United States has never defaulted on its credit before. However, by looking at the actual mechanics of a debt default it’s possible to get a better understanding of what might happen if Congress is unable to come to an agreement on the debt ceiling before in time.
Why haven’t we defaulted already? Hasn’t the debt ceiling already been hit?
Technically speaking, it has. The Treasury reached the statutory debt limit of $16.699 trillion on May 19th, but since then has been undertaking what’s known as “extraordinary measures”. Extraordinary measures include the government stopping reinvest into the Federal Employees Retirement System G-Fund, stopping investments to the civil service and postal retirement funds, and not reinvesting in the Exchange Stabilization Fund. All in all, this freed up about $303 billion worth of debt and has allowed the Treasury to continue issuing securities to pay off its obligations since mid-May. Understandably, these measures aren’t going to last forever.
When will these measures run out and cause the U.S. to default?
The Treasury is currently predicting October 17th as the day we will default if the debt ceiling isn’t raised. That’s the date when the extraordinary measures are expected to run out. It’s important to note that this isn’t an exact date, but rather the Treasury’s most recent estimation of when it’s “extraordinary measures” will be exhausted. On whatever day that occurs, the Treasury will be left with around $30 billion in cash on hand to pay off its debt obligations – not a great situation for an agency responsible for covering as much as $60 billion worth of expenditures every single day.
What happens first if we default?
The simplest explanation is that if the government defaults, it’s unable to issue the debt it needs to pay its obligations. This includes paying military personnel, Social Security and Medicare recipients, and state and local governments. Additionally, the government may not be able to pay individuals who hold matured Treasury bonds. The harrowing economic repercussions of such a scenario have led a number of individuals to advocate for the Treasury to engage in debt prioritization if a default does occur.
What is debt prioritization?
Debt prioritization is a term which has been tossed around by a number of members of Congress and financial analysts as a way for the United States to mitigate the impacts of a debt ceiling breach. Debt prioritization means that the Treasury would determine which payments are most important and would then use incoming revenue to pay off those payments while neglecting other obligations. Most people who advocate for this prioritization argue that bondholders and Social Security recipients should be placed first in the queue.
Is debt prioritization a realistic solution in the case of a default?
Yes and no, but mainly no. Both analysts at RBC Capital Markets and the Obama administration describe debt prioritization as impractical. Even this description is slightly off the mark. Debt prioritization, while technically within the realm of possibility would be highly unfeasible and almost guaranteed to be riddled with flaws. With over one-hundred million payments coming due every month, reprogramming Fedwire, the settlement funds transfer system that’s operated by the Federal Reserve and used for the real-time electronic transfer of funds between financial institutions, to prioritize certain payments over others would be a monumental task. Even if the Treasury Department was able to prioritize debt payments, there’s no precedent for whether or not they have the legal authority to do so.
How would defaulted Treasury bonds actually affect the economy other than preventing some people from getting paid what they’re owed?
In a pretty big way. The reason for this is because financial institutions fund many of their daily operations with something known as repurchase agreements. A common form of repurchase agreement (or repo, for short) is Treasury bonds which a bank or other firm will sell for X amount at the start of the day and agree to buy back for Y amount at the end of the day. The difference between X and Y is essentially the interest rate for this short term secured loan. Because Treasury bonds are almost universally believed to be safe financial instruments, there is no system in place in the repo market which would address the possibility that some Treasury bonds could be defaulted. This will create massive problems for financial institutions according to some analysts. Even if a default doesn’t occur, the threat of a default could cause the interest rate on repurchase agreements to skyrocket. In the run up to the 2011 debt ceiling crisis, repo rates increased from two basis points (0.02%) to twenty-eight basis points (0.28%) exacting additional costs on businesses and banks.
Oh, and the repo market isn’t a small part of our financial system either – it’s estimated to be between five and ten billion dollars in size according to the Federal Reserve Bank of New York.
Okay, I think I understand this problem with defaulted debt and repo markets, but how will it affect the economy as a whole?
If Treasury bonds are no longer a secure enough investment* to carry out these repurchase agreements, financial institutions are likely to start dumping Treasury bonds in favor of another financial instrument to use for repo purchases, possibly sovereign debt from another country. Financial institutions who use T-Bills for repo purposes aren’t going to be the only ones who want to get rid of their Treasury bonds either – many other investors may do the same. The result of this is that interest rates on Treasury bills will rise dramatically. The United States already spends approximately $223 billion, or six percent of the federal budget on interest payments for our debt. It’s not even possible to calculate how much that figure would change if interest rates increased significantly and didn’t return to normal for an extended period of time.
*It’s necessary to digress and explain what I mean by “secure enough investment”. There’s little doubt that this debt ceiling disagreement will be resolved at some point and that the United States will be able to honor its obligations eventually, but that’s not enough for firms who use Treasury bonds as money-like instruments. The reason is because even if Treasury bonds continue to trade at par or suffer a very minor hit, defaulted securities can’t be used as collateral Federal Reserve discount window – the system simply isn’t set up that way.
I’ve also heard a lot of talk that this will affect consumer confidence. What does that mean?
Another expected impact of a debt default – or even a close miss with a default – is that consumer confidence decreases. This is was one prominent effect of the near miss in 2011 when the United States came within a few days of defaulting on its debt. From May to August of 2011 (the debt ceiling deal was agreed upon on July 31st) consumer confidence fell by 22% and business confidence decreased as well. While other factors such as instability in European financial markets are alleged to have contributed to this decrease, it’s widely accepted that increased economic uncertainty and the wider risk spreads that result from that uncertainty have a negative impact on private spending. Multiple measures of consumer confidence have already begun to show a decrease in consumer sentiment during the month of September.
Will our credit get downgraded again?
Many Americans still remember when Standard and Poor, one of the three major credit rating agencies, downgraded the United States to AA+ for the first time in the nation’s history. This downgrade occurred on August 5th, 2011 only a few days after a debt ceiling deal was reached. The S&P report explaining the down grade cited the political brinksmanship of the past few months as one of the reasons behind the downgrade. This time is a little different, however. S&P recently stated that “The current impasse over the continuing resolution and the debt ceiling creates an atmosphere of uncertainty that could affect confidence, investment, and hiring in the U.S. However, as long as it is short-lived, we do not anticipate the impasse to lead to a change in the sovereign rating”. The S&P research note qualified that statement by adding that a protracted battle of an actual breach of the debt ceiling could change their calculus.
All this sounds pretty bleak. Is there any hope left?
Of course. All of this is predictions based off of something which may or may not happen. There’s still a chance for a “grand bargain” between House Republicans, Senate Democrats, and President Obama that would provide us with a long(er) term fix to the debt ceiling. There are also a number of other paths that could result in an agreement to raise our debt ceiling before we default, but that’s a discussion for another article.
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