What Happens If the U.S. Defaults on Its Debt?
Day nine of the government shutdown. Still no end in sight.
For 800,000 or so furloughed federal employees, this is tough. For most Americans, it's a mere annoyance.
But that could change in the coming weeks. Unless Congress lifts the nation's self-imposed debt ceiling, the Treasury will have less than $30 billion cash on hand on October 17, which will be wiped out quickly. According to the Bipartisan Policy Center, the Treasury will owe a $6 billion debt interest payment on October 31, $43 billion in Social Security and Medicare payments on November 1, and $29 billion in interest due on November 15. That makes defaulting on our debt frighteningly real.
Some say, no problem: The Treasury still brings in enough cash per year and per month to pay interest on the debt. But this misses the point that what matters is day-to-day cash flow. And there are plenty of days when the Treasury takes in far less than $10 billion in tax revenue. With reserves dried up and faced with an interest payment in excess of daily revenue, the country could indeed be forced to default if barred from borrowing more. This has little to do with deficits and lots to do with day-to-day cash-flow mechanics. Even immensely profitable companies utilize debt to bridge short-term cash-flow gaps.
The odds are still overwhelming that the debt ceiling will be raised and default avoided. But more serious investors are asking what was once an unthinkable question: What would happen if America defaulted on its debt?
A group of Congressmen responded this week with a shoulder shrug. "I understand Wall Street makes their money on trading these Treasuries, but Main Street? This has no impact on them," said Congressman Tim Huelskamp. "I think, personally, it would bring stability to the world markets," Congressman Ted Yoho explained when asked why he won't vote to raise the debt ceiling.
The U.S. hasn't defaulted on its debt in more than 200 years (save for a brief computer glitch in the 1970s). No one has any idea what will happen if default occurs because there is no precedent for it.
But to brush off a possible default as no big deal is outrageous. You don't need a deep imagination to picture it as something akin to the 2008 financial crisis on methamphetamine.
There are two things to keep in mind about Treasuries.
The global financial system is built on credit. That's just the way it is. And credit needs collateral. Lenders prefer safe collateral, and Treasuries are considered the gold-standard, "risk-free" asset. They are basically the cornerstone of the global financial system. According to Bloomberg, at least $2.8 trillion in Treasuries act as collateral in short-term lending markets.
Imagine you took out a $1 loan backed by $1 of Treasuries. You'll repay the $1 loan with cash you receive when your $1 of Treasuries are paid off by the U.S. government. But then, the government decides to default. Maybe it's only in default for a day or a week. But it means you can't repay your $1 loan on time. That means your banker comes knocking, forcing you to sell, say, your stocks, or your house. If you have nothing else to sell, the banker gets into trouble. Then his creditors come knocking. They want their money back. But your banker's assets are in Treasuries, too. Now those are in default. So your banker's banker is in trouble. And around we go -- until the credit market grinds to a halt, and you have an utter disaster on your hands.
Multiply this scenario by a few trillion, and you can imagine it wouldn't be very pleasant. "Well, holy cripes," was all Wells Fargo chief fixed-income strategist James Kochan could say when asked about Treasuries being pushed from the collateral market.
This is, effectively, what occurred in 2008, just with mortgage bonds rather than Treasuries.
Those holding bad mortgage debt fared the worst in 2008, but financial pain spread throughout the entire financial system, and to areas that had nothing to do with real estate. The reason was fear. If the global financial system is built on credit, it is supported by trust. When you remove trust, people hide now and ask questions later. The system freezes. I don't want to lend to you because you might hold something bad, or be lending to someone who is holding something bad, or be lending to someone who is lending to someone who is holding something bad. So people just wait. Credit stops flowing, and as we learned in 2008, that simply devastates the economy.
Even in a default, Treasuries will eventually be repaid -- that's a major distinction between now and 2008. But a credit crisis doesn't need to last long to bring the house down. Lehman Brothers was well capitalized two days before it was bankrupt.
The second reason default is dangerous is the likely rise in interest rates that would follow. It's a good thing when interest rates rise because the economy is growing faster than before. That doesn't necessarily even cost the government more money in real terms. But when interest rates rise because the market is pricing in credit risk, that comes right out of our pockets. Your pockets.
The list could go on: Not raising the debt ceiling would force the government to balance its budget overnight, almost certainly creating a new recession (Goldman Sachsestimates it would lop 4% off of GDP). It would strain foreign relations. It'd likely wallop the stock market. And make us look a bit silly, to put it nicely.
"Fun Fact," someone wrote on Twitter yesterday. "There is no actual crisis necessitating this manufactured crisis."
No one knows exactly what will happen if we default. It may, in fact be a minor event. But like Russian Roulette, I'm frankly OK not finding out.
More from the Motley Fool
My new report, "Everything You Need to Know About the National Debt," walks you through with step-by-step explanations about how the government spends your money, where it gets tax revenue from, the future of spending, and what a $16 trillion debt means for our future. Click here to read the full report!
The article What Happens If the U.S. Defaults on Its Debt? originally appeared on Fool.com.
Follow Morgan Housel on Twitter @TMFHousel. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.