Would a US Default Mean Disaster?

President Barack Obama says a failure to raise the U.S. debt ceiling would be Armageddon.

“The idea that this is catastrophic is wrong,” said Sen. Tom Coburn, R-Okla., on “Meet the Press” on Sunday. Coburn said, “What is catastrophic is to continue to spend money we don’t have.” Besides, he added “the debt limit doesn’t really mean anything because we’ve always extended it.”

Well, which is it? A failure to extend the debt ceiling would seem like it is either a catastrophe or not. You can’t be just a little bit “Armageddon” any more than you can be a little bit pregnant.

The latest debt ceiling news

Arguments that a failure to raise the debt limit will raise interest rates, slow U.S. economic growth, increase inflation and ultimately cost the United States its AAA credit rating are all true, but they don’t add up to an ultimate end-of-the-world battle. The inability to deal with something as relatively simple as raising the debt ceiling is a symptom of fiscal dysfunction in Washington that will push the U.S. further down the road to economic stagnation. But the image that comes to my mind is that of a frog cooking to death in a pot of water that heats up so slowly the frog never jumps out, rather than fire blasting from heaven to devour Gog and Magog.

Mind you, there is a possibility that failure to raise the debt ceiling could set off a catastrophe in the financial markets along the lines of the Lehman Brothers meltdown. But no one seems to be talking about how that could happen — maybe because it’s too complicated for us rubes to understand or maybe because it’s another example of why the current system of global finance needs to be torn down and completely rebuilt. Come to think of it, it couldn’t be that second reason, though — Wall Street and Washington would be fine showing everyone how the sausage is made. Really, they would.

Understanding the problem

The problem posed by the debt ceiling is actually pretty simple. Every month the United States takes in less than it spends. The gap has averaged $125 billion a month in 2011. In February, the monthly deficit hit $223 billion, which was a record. May, a very good month for revenue inflows saw the lowest deficit for that month in five years — but that deficit still hit $59 billion. It was also the 32nd consecutive monthly deficit. The cumulative red ink pushed the federal government right up to the current debt ceiling of $14.29 trillion on May 16. The U.S. Treasury has been juggling accounts ever since by, for example, delaying internal transfer payments, but it will run out of gimmicks on Aug. 2, according to its calculations. At that point, the federal government will have to stop spending more than it takes in — unless Congress raises the debt ceiling to allow more borrowing.

Going cold turkey on debt is made more difficult because some parts of federal spending are climbing automatically. As of May, spending formulas increased the cost of Social Security, Medicare and Medicaid by 3.6%, 3.8% and 5.4%, respectively, in 2011 from 2010, according to the Congressional Budget Office. The biggest jump came from spending on the public debt, up 16% from 2010.

If the Treasury can’t juggle cash internally to avoid running up against the debt ceiling, then it will have to juggle externally to bridge the average $125 billion monthly gap. In June, the interest due on the U.S. debt came to $110 billion, but most months it’s closer to $30 billion. The government sent out about $60 billion in Social Security checks in May. Not sending out Social Security checks and not paying interest on Treasury debt would go a long way to closing the monthly gap.

The consequences of failure

Here are the five arguments Obama is making for raising the debt ceiling:

First, at least one core function of the U.S. government — with lots of public support — is going to take a big hit if the United States suddenly has to live within its revenue. What’s it going to be? Social Security? Veterans’ benefits? Pay for active-duty military personnel? Interest on Treasury debt?

Want to avoid hitting a big, politically powerful group hard in your efforts to fill the gap? Can’t be done.

Eliminating the entire budget for the Smithsonian museums, for example, would save just $800 million over a year, or about $67 million a month. Completely zero out the NASA budget and you reduce the gap by about $1.6 billion a month. Cut the Environmental Protection Agency’s budget completely and the monthly gain is $750 million. Even combined, they’re peanuts compared with that $125 billion gap. To close the gap, you’ve got to go after the big programs that have been responsible for bringing the current negotiations over the debt ceiling to deadlock.

Second, cuts of this magnitude will, in the short term, send the U.S. economy back into recession. In the first quarter of 2011, the U.S. economy showed a 1.9% annual real rate of growth (after subtracting the effects of inflation on the value of goods and services produced here). That resulted in the U.S. economy growing (once again after subtracting inflation) by a whopping $64 billion. That’s only about half as big as the monthly cuts that would be necessary to fill the revenue gap in the event of a failure to raise the debt ceiling. Yes, in the long run the U.S. debt of $14.3 trillion is a powerful drag on growth in the U.S. economy. But in the short run, reducing the government’s spending by $375 billion a quarter in borrowed money will depress economic growth.

Third, trying to run a government without either a surplus or the possibility of adding additional debt to balance out month-to-month swings in revenue and spending will produce massive uncertainty. So what does Treasury do when interest payments balloon in June and December as they do every year? Does the government cut back on interest payments even more that month and then increase payments in January and July? Tax receipts don’t come in evenly over the course of a year, either.

Fourth, all this uncertainty and chaos will add to the interest rates the United States must pay on its debt. Stands to reason, doesn’t it? U.S. Treasurys have been used as the definition of a risk-free investment because buyers could count on the U.S. always paying its bills and behaving reasonably responsibly. Now both of those attributes deserve serious re-examination. And even if Congress does come up with a deal that extends the debt ceiling, major damage has already been done to U.S. credibility. Imagine that you’re an overseas investor following the current debate in Washington. You’ve heard U.S. politicians say that a default is better than raising the debt ceiling. You’ve heard statements that have basically challenged you to find another place to put your money. And you’ve seen politicians willing to sacrifice bond investors to short-term domestic politics. Every investor in the world has got to be asking: “How soon can I find an alternative investment for some of my Treasurys?”

Fifth, none of this is good for the long-term trend in the U.S. dollar. Standard & Poor’s has put the U.S. AAA rating on credit watch with negative implications. The credit rating company has said that if a credit downgrade happens, it could come within the next three months. This, like the uncertainty surrounding the debt ceiling fight and the demonstrated inability of U.S. politicians to come up with a plan for addressing the long-term U.S. debt problem, has eroded the desire of overseas investors to hold dollars. Until Washington can demonstrate a real plan to reduce the projected growth in U.S. debt, I think the dollar will be locked into a downward trajectory. That adds to the upward pressure on U.S. interest rates, of course, as well as the downward pressure on the U.S. standard of living.

All this adds up to serious pain for the average American. Even if you aren’t a member of one of the groups that winds up paying for a failure to extend the debt ceiling, you’re still going to pay the price in slower growth and higher interest rates.

But I don’t see Armageddon here. Interest rates won’t go up overnight. In fact, they may not go up at all until the euro debt crisis is “solved.” And even then, U.S. interest rates are likely to climb slowly because U.S. Treasurys are such a big part of the global portfolio that it’s hard to find alternatives overnight. (Nonetheless the U.S. debt ceiling crisis, like the larger U.S. debt crisis, is good for gold and other commodities and for currencies such as the Canadian and Australian dollars, the Swiss franc, and the Norwegian krone.)

(MSN Money)

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