Anatomy of a Debt Default in the United States

June 29, 2011 — -- While many economists say a genuine default is unlikely because politicians in Washington will ultimately agree on a way to raise the debt ceiling, naysayers in Washington have downplayed the potential consequences such as higher interest rates and inflation.

Republican presidential candidate Rep. Michele Bachmann of Minnesota called predictions of an economic apocalypse "scare tactics" and former Alaska governor and vice-presidential candidate Sarah Palin criticized fellow Republicans for seeking more time to negotiate.

"Hype re: "need" to incur more debt NOW is nonsense," Palin tweeted, seeming to suggest the debt ceiling should not be raised.

The president hosted separate meetings this week with the Senate leaders of both parties in the Oval Office, attempting to break the impasse on spending cuts and tax hikes.

What would actually happen if the United States blew through the Aug. 2 deadline set by Treasury Secretary Tim Geithner is the subject of intense debate.

Colleen Murray, spokeswoman for the Treasury, said in a statement Tuesday "it is unlikely that the date will move by more than a day or two, if at all."

Although the Treasury usually is able to practice accounting techniques to meet its obligations, there is some risk the government might not make immediate payments for bond obligations, certain government salaries and social welfare payments, said Kent Smetters, former deputy assistant secretary for economic policy with the Treasury and former economist with the Congressional Budget Office.

"It's not going to happen immediately, but internal transfers can't go on forever," Smetters said.

When the Treasury Department practiced internal transfers in the past, Smetters added, "it had absolutely no bearing on anyone outside the federal government."

But if the government stopped making payments, it could potentially resort to paying IOUs that are not backed with full-facing credit, as the state of California has done. That could lead to problems if someone with, say, a military salary was not able to deposit an IOU with a bank, or a store would not receive it as a payment, Smetters said.

When California issued IOUs in 2009 when it could not meet its debt obligations, Smetters said, a small trading market developed around the IOUs. Initially, the discounts on the IOUs were as steep as 80 cents to the dollar.

"Eventually, people in California realized it was pretty irrational so the discounts got smaller and smaller," he said. "People will eventually figure out that government will pay."

Peter Morici, former director of the U.S. International Trade Commission's Office of Economics, said a genuine default, in which the United States is unable to honor all its debts for that day, though unlikely, would have grave repercussions, even outside the United States.

"The consequences would be very large if there was an absolute, genuine default," Morici, an economist and business professor at the University of Maryland, said. "It might cause the global financial system to go into disarray like in 2008 ... which will be virtually impossible for the Treasury, IMF [International Monetary Fund] or anyone else to stop."

Geithner told Speaker of the House Rep. John Boehner, R-Ohio, in a letter in May the United States must raise its statutory $14.3 trillion debt ceiling by Aug. 2 or risk defaulting.

He wrote that a default "would have a catastrophic economic impact that would be felt by every American," creating a financial crisis "potentially more severe" than the most recent crisis.

"A broad range of government payments would have to be stopped, limited or delayed, including military salaries, Social Security and Medicare payments, interest on debt, unemployment benefits and tax refunds," he wrote.

Geithner also said there would be higher interest rates and borrowing costs, declining home values and reduced retirement savings for Americans.

Credit rating agency Moody's Investors Service said it would put the U.S. credit rating under review for a possible downgrade unless Congress shows progress in negotiations by mid-July to increase the debt limit. If a default were to occur, Moody's said it would "likely" downgrade the U.S. government's rating "shortly thereafter."

Even if a default is avoided, Moody's said it could review the government's "stable" outlook and change it to "negative," dependent on any progress toward long-term deficit reduction.

As Aug. 2 approaches, the bond market could show signs of panic, demanding higher yields on U.S. debt, economist Morici said.

"That might cause bondholders to seek giant swaps on U.S. debt," he said.

An actual default would confound the expectations of bondholders and most of the financial services sector, which had expected little to no risk when purchasing U.S. debt, Morici said.

"The U.S. would never regain its gold-plated standing in the bond market," he said.

It is possible that Obama could initiate a government shutdown if the debt ceiling is not raised in time in order to meet some of the government's liabilities, Morici said.

He said taxes cover about 65 percent of government spending while borrowing supports the rest.

"We could do a lot of things on 65 percent of the money," Morici said. "We couldn't do everything, but we could do a lot."

Morici said regardless whether the government had even a short-term default or shut down temporarily, the deficit will still widen over time.

"We just have to act soon," Morici said. "We really need to get things under control."

Smetters said it is Geithner's job as Treasury secretary to create a "dire scenario" but the United States will "absolutely" pay back what it owes.

"That's not really the issue," Smetters, a professor at the Wharton School at the University of Pennsylvania, said. "The issue is how will it pay back what it owes? The concern is it will pay its obligations by printing more money."

A Default is "Unthinkable" to Some

Smetters, also president of Veritat Advisors, which provides financial planning to "mainstream households," said citizens could be greatly affected from the resulting inflation.

He said even if the United States does not default on its debt but instead prints money in the years to come to meet its obligations, inflation would lead to decreasing value of each dollar.

"We're making such huge promises we can't keep," Smetters said. "The incentive to create more debt and inflate our way out is too enticing for the government."

Smetters said an extreme example of a country with an inflationary environment is Zimbabwe. There, the Reserve Bank of Zimbabwe has printed an oversupply of Zimbabwean dollars, leading to denominations of Zimbabwean dollars in the billions.

Jay Powell, visiting scholar at the Bipartisan Policy Center and former under secretary of the Treasury for finance under President George H.W. Bush, said it is "very unlikely" there will be a default in the United States.

"A default is unthinkable and potentially catastrophic," Powell said.

Powell said the agreement has to be reached as soon as possible and will likely be reached well before Aug. 2.

"I hope all sides will come to their senses before it comes to that," he said. "The parties are negotiating an agreement that will involve spending cuts and a strong enforcement mechanism to tie the hands of future congresses."