The global economy faces a bizarre man-made threat: Radical legislators in the U.S., issuer of the world’s most trusted currency, think forcing the government to renege on its obligations is a good way to shock it into recognizing the error of its fiscally imprudent ways.
Lest anyone take this notion seriously, here’s what would happen if that threat were carried out. To keep spending, the government needs Congress to pass a spending law. Republicans have already blocked this—holding the budget hostage to defunding Obamacare, a settled law—resulting in a partial government shutdown. Now they’re threatening the separate and much more disruptive step of refusing to raise the federal debt ceiling, currently set at $16.7 trillion. Spending exceeds revenue; without permission to borrow more, the government won’t be able to pay its bills even if a law allowing spending goes through. If the debt ceiling stays in place, the Treasury will run short of cash soon after Oct. 17. At that point …
1. Global markets will see the U.S. government as grossly and dangerously incompetent. Refusing to raise the debt ceiling is fundamentally different from cutting the government’s funding. It’s as if Congress were sending the Treasury two contradictory and legally binding orders: one that requires it to make hundreds of billions of dollars a month in payments and another that prevents it from borrowing the money it needs to do so. Which order is the Treasury supposed to obey? This is the stuff of absurdist theater. Confidence matters, and an event like this will destroy confidence.
2. Forced spending cuts will kill the economic recovery. Over the course of a year, the Treasury borrows roughly $1 out of every $5 it spends, so hitting the debt ceiling would require it to cut outlays by about a fifth—and by much more in the short term, because flows into and out of the Treasury are lumpy. Such a severe fiscal squeeze would crush a still-tentative recovery at a time when widespread unemployment is threatening to do permanent damage to the country’s productive capacity.
3. The U.S. government might actually default on its debts. Some in Congress apparently believe that hitting the debt ceiling doesn’t necessarily mean the government will miss a payment on its $12 trillion in bonds outstanding—an event that markets would call a default, which could trigger a financial catastrophe (see No. 4). The House of Representatives has passed legislation to authorize the Treasury to prioritize such payments.
Even if the Senate passed that measure, which it’s refused to do so far, it might not be enough. The Treasury processes more than 80 million separate payments a month, using an ancient system that wasn’t designed for debt-ceiling damage control. Money to bondholders goes through a separate channel called Fedwire, so some segregation might be possible; but accidents are all too probable, and a payment could easily go missing.
Markets are aware of the risk: Yields of Treasury bills maturing in the second part of October are abnormally high, suggesting that investors are demanding compensation. The cost of insuring against a U.S. default has almost doubled.
4. A default could trigger a global crash. Treasury bonds are the foundation of the U.S. and global financial systems. Their yields serve as benchmarks for interest rates on mortgages and corporate bonds. Securities dealers in the U.S. hold about $1.9 trillion in Treasuries as collateral on loans to hedge funds, banks, and other financial companies. Mutual funds, pension plans, and corporations rely on interest payments from Treasuries to meet their obligations to investors, retirees, and workers.
The slightest concern about the U.S. government’s ability or willingness to pay could prompt investors to demand a higher return on the bonds, and lead dealers to toughen the terms on which they accept Treasuries as collateral. That would abruptly raise the cost of credit for everyone—or else paralyze financial markets altogether. Economists have estimated that a few missed Treasury bond payments in 1979, the result of a brief technical glitch, pushed up interest rates by 0.6 percentage point and increased the U.S. government’s borrowing costs by $12 billion a year.
It’s hard to overstate the danger. Picture a crisis in which markets freeze and the U.S. government is unable to act because its own creditworthiness was the cause of the panic.
5. The government’s fiscal problems will only get worse. It’s true that U.S. finances are on a troubling long-term trajectory: The government has promised more to future retirees than taxpayers seem willing to pay. But in the current impasse, that issue has received scant attention. Meanwhile, heightened fears among investors will increase the government’s cost of borrowing. An increase of even 1 percentage point would raise the government’s costs by $120 billion a year.
The longer-term fiscal problem is solvable. Threatening a sovereign default, with all the enormous risks that entails, is not part of the solution. Arguing otherwise carries irresponsibility into the realm of insanity.