Banging Our Heads Against the Debt Ceiling: Here's Why It'll Hurt

As the government shutdown wends its way into its second week, an even larger crisis is looming on the horizon. Back in May, the U.S. government hit its debt ceiling -- the limit on how much money it is legally allowed to borrow to cover its bills. Since then, Treasury Secretary Jacob Lew has managed to continue financing the federal government by borrowing from various programs, including federal pension funds, but on Oct. 17, Lew claims, that the government will be down to about $30 billion. Given that it pays out about $60 billion per day, that means Washington will start defaulting on its debts.

What will happen if America starts defaulting? Depending on who you talk to, the impact of a default could range from minimal to apocalyptic. Most experts, however, agree that a few things would happen:

The Government Could Stop Cutting Checks

In a January letter to Congress, then-Treasury Secretary Tim Geithner laid out many of the benefits and payments that the government makes every month, including "Social Security; Supplemental Security Income; Medicare; Medicaid ... military salaries, military retirement, veterans' benefits ... federal employee salaries and retirement...unemployment insurance." He went on to note that "If Congress does not act to extend borrowing authority, all of these payments would be at risk." In other words, if you're expecting a check from the federal government on Nov. 1, you may be in for a wait.

Government Contractors Would Take a Hit

The U.S. government works with literally thousands of contractors to provide everything from weapons systems to vehicles to health care. If we hit the debt ceiling, the government won't be able to pay these companies. They, in turn, would have to lay off workers, default on their own contracts, lose revenues, and deal with falling stock prices.

Borrowing Would Get a Lot More Expensive

Right now, the U.S. government is able to borrow money easily and at a very low interest rate, which it does by selling Treasury securities. Its interest rate, in turn, is low because the government always pays its bills. If we hit the debt ceiling, the government won't be able to pay its bills, which means that its credit rating would fall and its interest rate would rise. This, in turn, would affect everything that uses Treasury securities as a benchmark, including car loans, college loans, and so on. In other words, if you have a variable rate loan, you could expect to see your monthly payments go up. And, if your pension fund or 401(k) is invested in Treasury securities, you could expect to see a BIG hit in the value of your holdings.

Unemployment Would Rise

For the most part, the checks that the government sends out every month don't sit around in bank accounts. Instead, Medicaid and Medicare reimbursements, Social Security checks, military salaries, contractor bills and other payments stimulate massive economic activity as beneficiaries spend their money. If that flow of money dries up, retail revenues will follow. Companies, losing money, will look to cut expenses by trimming their payrolls.

The Stock Market Would Take a Tumble

The stock market tends to be skittish in the best of times, and it's already experiencing a downward tilt thanks to the government shutdown. %VIRTUAL-article-sponsoredlinks%But between rising borrowing costs for the federal government, falling contractor revenues, and upward pressure on unemployment, it isn't hard to imagine how it would react to a debt ceiling default. For that matter, the 2011 debt ceiling battle gives us a preview: At the time, the S&P 500 took a shocking 20 percent tumble in value. In other words, even if you aren't directly invested in government securities, a debt ceiling default will still hit your investments pretty hard.

Total Mayhem

It's hard to imagine a scenario in which the debt ceiling default would continue for more than a few days. Then again, not so long ago, it was impossible to imagine a default at all, so we should avoid making assumptions. An extended default period -- if one should occur -- would have a devastating effect on pretty much anything involving money. With banks struggling to stay afloat and credit in disarray, one scenario suggests that access to money could dry up. In other words, if you pay for your groceries with a credit card, get ready for trouble.

Even if your bank is still working, a burst of inflation could be a real problem: A large part of the reason U.S. currency is so stable is because world financial markets trust in the full faith and credit of the U.S. government. If that faith is shaken -- by a totally avoidable, politically-motivated default, for example -- the value of the dollar could plummet, sending the costs of food and goods through the roof.

On the other hand, a counter-argument to that inflationary conjecture is playing out right now in the world currency markets, where the dollar is actually gaining strength. Turns out being the world's reserve currency is a powerful position, even when you're playing political chicken with the global economy: Foreign financial institutions are required to use dollars to conduct business, and if Washington defaults, the supply of greenbacks will tighten up significantly -- which will make dollars worth more. As long as international markets demand dollars, we may be cushioned against some of those inflationary shocks.

But Really ...

In truth, apocalyptic scenarios are extremely unlikely. A more likely outcome is that Congress fights with President Obama right up until the final hour (or just past it), the stock market gets spooked, and the debt ceiling is eventually increased. In the short term, the crisis would be averted, but -- once again -- the markets would get a reminder that Congress is able to hold the U.S. economy hostage. This, in turn, would likely lead to a further downgrade of the U.S.'s credit rating, making it more expensive to borrow money and putting a further strain on an already strained economy. Everything, in other words, would get a little bit lamer.

And, in case this seems a bit unrealistic, just keep in mind: it's basically what happened in 2011, the last time we went through this mess.

Bruce Watson is DailyFinance's Savings Editor. You can reach him by e-mail at bruce.watson@teamaol.com, or follow him on Twitter at @bruce1971.