Could the U.S. Survive a Default? Debt Ceiling and Continuing Resolutions

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Congressman Mike Lee has been one of the Tea Party leaders willing to breach the debt ceiling to drive home his point. Credit: By US Congress

Utah Congressman Mike Lee has been one of the Tea Party leaders willing to hold to the debt ceiling to drive home his point. Image courtesy of US Congress.

It is simply science fiction fantasy to say that if you do not raise the debt ceiling, everything is going to collapse — Mike Lee

Over the past sixteen days, the United States suffered twin black eyes domestically and across the globe, thanks to the economic damage caused by its political dysfunction as well as a credibility hit on the world stage over flirting with default by breaching its legislated $16.7 trillion debt ceiling.

The political infighting which led to partisan brinksmanship was over a series of interrelated issues, including delaying or defunding Obamacare, curtailing projected budget deficits, and various entangled philosophical differences.

Although the President has signed a short-term deal to re-open the government and avoid default by increasing the debt ceiling, a combined 162 members of both chambers voted against the bipartisan deal — essentially voting in favor of default.

With that many legislators willing to go over the cliff, it begs the following question: Would refusing to extend the debt ceiling actually cause an economic disaster?

The U.S. Budget is Essentially a Gigantic Profit and Loss Statement

Although the accounting rules vary somewhat, in a big-picture sense, the United States budget is much like a business’ profit and loss statement. Taxes represent the lion’s share of revenues, and budgeted line items are akin to operating expenses. Unlike the private sector, the government can (and has) operated at a persistent loss, with budget deficits financed indefinitely by the sale of Treasury instruments.

Indefinitely, alas,  does not mean ‘forever.’ The accumulated debt from decades of deficits has mounted over the years and stands at approximately $16.7 trillion, or roughly 100% of the size of the economy. While nobody knows where the tipping point is, virtually all economists agree that although the pace has slowed, the trajectory is still moving the wrong direction and is unsustainable over the long term.

The philosophical battles in Congress aren’t so much over whether or not something should be done about it, but how to solve the problem. The threat of default is viewed by many as a leverage point.

Does the Debt Ceiling Serve a Purpose Today?

A number of pundits, politicians and economists believe we should simple eliminate the debt ceiling, as it  represents an anachronism from nearly 100 years ago and is not utilized by any other country in the world outside of the U.S. and Denmark. That being said, many politicians believe it serves as the impetus necessary to force the parties to the table to change the country’s financial equation.

Regardless, given that the debt ceiling does exist, and legislates a maximum debt limit the United States can carry by law, the failure to increase the debt ceiling would constitute the potential for a debt default, as the government could not borrow more money to finance burgeoning deficits.

U.S. Default: What Would Happen?

Nobody knows exactly what would happen if the United States breached the debt ceiling and defaulted on its obligations, but a number of resulting consequences seem likely, including the following:

Increases in interest rates: This is a virtual certainty, as a panicked sell-off of government debt would cause the prices to go down (lower demand). In the bond market, as price goes down, yield must rise accordingly.

Stock market turmoil: Similarly, there is little doubt that the stock markets would tumble. On September 28, 2008, the Dow dropped 778 points upon news that Congress failed to pass the $700 billion bank bailout plan. A debt default would likely cause a fall of that magnitude — or worse.

A run on the banks: As with the market crash of 2008, investors and depositors would quite possibly pull their funds out of banks, money markets and other repositories of funds in droves, which could cause another wave of institutional failures.

Recession: A sudden, sharp recession would likely strike the United States, spreading across the globe. Government spending alone represents a substantial portion of GDP, and with consumer confidence dropping to the floor, businesses and individuals would tighten their belts, further causing discretionary spending to diminish.

Drastically reduced government: With expenses topping revenues and no way to cover the difference, the government would simply be unable to provide the same degree of services that it does today.

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