Debt Ceiling: What US Government Default Would Mean For You

July 12, 2011 -- In almost any other year, Aug. 2 would be just another midsummer day. But, as most Americans have probably heard by now, this Aug. 2 is the deadline for Congress to raise the nation's $14.29 trillion debt ceiling to prevent the U.S. government from defaulting on its obligations.

But what does that really mean? What's likely to happen next month if Washington lawmakers, who've made little headway toward a deal, fail to strike an agreement to raise the debt limit?

The Obama administration says it would mean financial apocalypse.

"The credit-rating agencies around the world have said if Congress doesn't act by the 2nd, they will downgrade our credit [for] the first time in history," Treasury Secretary Tim Geithner said Sunday on NBC's "Meet the Press." "And if that happens, you're going to see catastrophic damage across the American economy and across the global economy."

Republicans, on the other hand, say that's a bunch of nonsense. With the fight for the GOP presidential nomination heating up, some of the top candidates have urged their colleagues on Capitol Hill not to raise the debt limit, despite the administration's dire warnings.

"I will not vote to increase the debt ceiling," Rep. Michele Bachmann, R-Minn., vowed in a television ad last week, a stance echoed by fellow presidential candidates Tim Pawlenty, the former Minnesota governor, and Rep. Ron Paul, R-Texas.

So who should Americans believe? Could Aug. 2 be the beginning of an economic apocalypse or can it be ignored in an effort to combat the country's soaring deficits?

JD Foster, an economist at the right-leaning Heritage Foundation, said a failure to raise the debt limit by Aug. 2 would result in consequences for the government, but that talk of financial Armageddon is overblown. If the debt limit is not raised come Aug. 2, the government will have to pay its bills solely using incoming cash flows.

"What we know at that point is we don't have the borrowing capacity or the revenues to make payments on all the bills and promises that Congress has legislated and the president has signed, so we'd be short on cash," Foster said.

"As Geithner put it, we would then be in default on our obligations. That's an important expression because when Congress passes a law that the president signs, saying you're going to spend something, you have a legal obligation to make good on that spending promise. It doesn't mean, however, that on Aug. 2 we will default on our publicly held debt. That's a different issue."

In other words, if the debt limit is not raised, the U.S. government would no longer have the cash to cover its expenses. That could mean no Social Security payments, no benefits for veterans, no pay for members of the military and other government workers, or the shutdown of federal programs. It could also mean not paying bondholders, but that would be an unprecedented default, a scenario seen as highly unlikely.

Imagine Junk Rating for U.S. Debt

"The key issue there is would the administration be able to prioritize so that when the interest on the outstanding debt came due, they would have the resources to be able to make those payments?" Foster said. "That's why the markets for the most part have not really worried too much about the near-term effects of this because they are pretty confident that Geithner would in fact make all the interest payments on the debt. The markets aren't really in any doubt that the interest will be paid and the full faith and credit of the U.S. government will be protected, so all of this talk about Armageddon --- from a Wall Street perspective -- is laughable. It's pure political rhetoric ...

"But something very dramatic would happen on Aug. 2 and that is federal spending would be cut by some 40 percent and nobody really knows how the government is going to then prioritize spending past the interest expenses," he cautioned.

The idea outlined by Foster, known as prioritization, has been met by opposition from Geithner and Federal Reserve chairman Ben Bernanke, among others. Geithner denounced it as "unworkable," while Bernanke warned that it could "create serious concerns about the safety of Treasury securities."

In addition, discretionary spending includes such vital components as the nation's air traffic control system and rent subsidies, so picking and choosing which expenditures would be cut and which would continue would be no small feat.

Jerome Powell, who worked at Treasury under President George H. W. Bush, said in a report for the Bipartisan Policy Center that contrary to suggestions from people such as Foster that prioritization is possible, "The reality would be chaotic: unfair results, unanswered questions; Treasury picking winners and losers; public uproar; [and] intense global media focus."

If the government were unable to manage its payments despite no more incoming cash, it would default. Then major credit rating agencies would downgrade the U.S. debt, forcing Treasury bondholders to sell their holdings because many investors have requirements that their holdings be highly rated. For instance, one official at Standard & Poor's said, the agency would downgrade the United States from the top rating of AAA down to D; a junk rating.

Then, once the default is resolved, the government would see an immediate increase in the interest rates it has to pay in order to borrow money, the same way a family that misses some of its mortgage payments would also see an interest-rate increase. JP Morgan and PIMCO have both said a default would result in a 0.5 percent increase, something that could mean an extra $10 billion a year in interest rate payments and $75 billion a year over time as the country refinances its short-term debt.

In turn, that would mean higher interest rates for consumers because the rates that consumers pay for mortgage, auto, student and credit loans are tied to what the federal government pays. Such a sequence of events would send the stock market into a tailspin, the likes of which could make the crash in the fall of 2008 seem minor. JP Morgan estimated that the market could drop by close to 9 percent in the three months after a default.

Default Could Exacerbate Unemployment

On a global scale, the U.S. dollar could be tarnished beyond repair. The currency remains the gold standard in world finance, but a missed payment by the U.S. government could change all that. The Chinese, for instance, could start dumping their dollars. Treasury bills have long been viewed as the world's safest investment, but a default could see gold take that title.

Banks, of course, would also react. Business loans could dry up, a development that would result in significant job losses. Take the existing lending environment, where banks are already reluctant to borrow and jobs are already hard to find. Any default by Uncle Sam would almost certainly make matters dramatically worse.

At a news conference at the White House Monday, President Obama urged lawmakers to come to an agreement to raise the debt limit and prevent any of the aforementioned developments from taking place.

"My hope is that as a consequence of negotiations that take place today, tomorrow, the next day and through next weekend, if necessary, that we're going to come up with a plan that solves our short-term debt and deficit problems, avoids default, stabilizes the economy and proves to the American people that we can actually get things done in this country and in this town," he said.

"Let's step up," he urged. "Let's do it."

But with Washington at a standstill because of partisan gridlock, it might be a tall order for lawmakers to do anything. And if they fail, it is clear, the consequences could be felt far and wide for a long time to come.

ABC News' Dan Arnall contributed to this report.