U.S. Debt Default Causes and Consequences
Will the United States ever default on its debt?
In October 2013, Congress threatened to stop raising the debt ceiling unless the president cut back spending on Obamacare, Medicare, and Medicaid. At the last minute, Congress agreed to raise the debt ceiling, but the damage was done. During the three weeks that Congress debated, investors seriously wondered whether the United States would actually default on its debt.
America has never defaulted on its debt. The consequences are unthinkably dire. But this was the second time in two years that House Republicans resisted raising the debt ceiling. The consequences of a debt default may become all too real in the very near future.
How the United States Could Default on Its Debt
There are two scenarios under which the United States would default on its debt. This first would happen if Congress didn't raise the debt ceiling. Former Treasury Secretary Tim Geithner, in a 2011 letter to Congress, outlined what would happen:
- Interest rates would rise, since "Treasurys represent the benchmark borrowing rate" for all other bonds. This means increased costs for corporations, state and local government, mortgages, and consumer loans.
- The dollar would drop, as foreign investors fled the "safe-haven status" of Treasurys. The dollar would lose its status as a global world currency. This would have the most disastrous long-term effects.
- The U.S. government would not be able to pay salaries or benefits for federal or military personnel and retirees. Social Security, Medicare, and Medicaid benefit payments would stop, as would student loan payments, tax refunds, and payments to keep government facilities open. This would be far worse than a government shutdown, which only affects non-essential discretionary programs.
The second scenario would occur if the U.S. government simply decided that its debt was too high and it stopped paying interest on Treasury bills, notes, and bonds. In that case, the value of Treasurys on the secondary market would plummet. Anyone trying to sell a Treasury would have to deeply discount it. The federal government could no longer sell Treasurys in its auctions, so the government would no longer be able to borrow to pay its bills. In other words, any default on Treasurys would have the same impact as one resulting from a debt ceiling crisis.
Even the Threat of a Debt Default Is Bad
Even if investors only think the United States could default, the consequences could be almost as bad as an actual default. U.S. debt is seen worldwide as the safest investment anywhere. Most investors look at Treasurys as if they were 100 percent guaranteed by the U.S. government. Any threat of a default could cause debt rating agencies, such as Moody's and Standard and Poor's, to lower the U.S. credit rating.
To give you an idea of just how bad a lower credit rating could be, in April 2011 S&P only lowered its outlook on the U.S. debt from "stable" to "negative." As a result, the Dow immediately dropped 200 points and gold gained $10 an ounce.
Impact on the Economy
A U.S. debt default would significantly raise the cost of doing business. It would increase the cost of borrowing for firms. They would have to pay higher interest rates on loans and bonds to compete with the higher interest rates of U.S. Treasurys. All U.S. interest rates would rise, increasing prices and contributing to inflation. The stock market would also suffer, as any U.S. investment would be riskier. Stock prices would fall as investors fled to other countries' safer stocks or gold. For these reasons, it could lead to another recession.
How the U.S. Government Can Avoid Default
The surest way to avoid default is to prevent budget deficits that lead to debt. The federal government must raise revenue through taxes or cut spending. But now that the debt is more than 100 percent of gross domestic product, it will be difficult to cut spending enough to reduce the debt and risk of default.
The other option is to allow the dollar to depreciate enough to make the debt worth less to foreign debt holders, like China and Japan. The Federal Reserve does this by monetizing the debt. It buys Treasurys with credit it creates itself. Default can be avoided if the Fed doesn't require the interest to be repaid.
Other Countries That Have Defaulted on Their Debt
In 2009, Iceland defaulted on $62 billion in debt incurred by banks it had nationalized. The country's GDP was only $14 billion. As a result of the banks' collapse, foreign investors fled Iceland, prompting the value of its currency, the krona, to drop 50 percent in one week. It created massive inflation and soaring unemployment.
That same year, Dubai defaulted on debt created by its business arm, Dubai World. Its assets were all in real estate, so when values plummeted, it didn't have the cash to meet its obligations. Eventually, Dubai negotiated lower debt payments, known as debt restructuring.
The U.S. debt is so much larger than that of either Iceland, Dubai, or Greece. As a result, a U.S. debt default would have a more negative impact on the global economy.