A lost generation: What would happen if the US defaults on its debt?

Last week, the US Treasury released a report on the global consequences of a default. It makes for stark reading.

Its conclusion reads:

“In the event that a debt limit impasse were to lead to a default, it could have a catastrophic effect on not just financial markets but also on job creation, consumer spending and economic growth with many private sector analysts believing that it would lead to events of the magnitude of late 2008 or worse, and the result then was a recession more severe than any seen since the Great Depression.

“Considering the experience of countries around that world that have defaulted on their debt, not only might the economic consequences of default be profound, those consequences, including high interest rates, reduced investment, higher debt payments, and slow economic growth, could last for more than a generation.”

America has never defaulted on its debt. It has never had need to. It still has no need to.

But a political impasse means its $16.7 trillion debt ceiling is being used as a bargaining chip by Republicans to ensure the scrapping or delay of legislation passed by Democrats in the previous political cycle.

The American government is already shut down and has been for nine days, as Congress Republicans refuse to put a budget to a vote unless it cuts funding to President Obama’s healthcare reforms.

But a bigger day is coming. On October 17, America is scheduled to breach its debt ceiling.

And while few think it’ll come to that, here’s what would happen if it did:

October 17

America will breach its debt ceiling on October 17, given current spending and taxation flows.

That means the Treasury Department would not be allowed to borrow more money to pay its expenses.

In its report, the Department says it will have $30 billion on hand, which it will use to pay what it can.

Treasury Secretary Jacob Lew has said there will be $30 billion on hand to use on this date to pay the bills, an amount he said was “not responsible”.

All government spending goes through Treasury, so that $30 billion will be quickly eroded by scheduled payments to government programs like Social Security.

October 30

This is when Treasury says it will run out of money. This is just for domestic spending. A lot of government departments are already shut down, but this means essential services currently exempted – schools and defence contractors, for example – would begin to be affected.

October 31

This is the point of no return. America owes a $6 billion interest payment on this day, and the money to pay it would not be available.

“This is when the proverbial would hit the fan,” AMP Capital’s chief economist Shane Oliver tells SmartCompany. “America’s never defaulted in that sense before. Greece came close a few months back, but that didn’t matter. Greece isn’t core to the global financial system.”

If America were to fail to make that repayment, credit rating agencies would have to class it as being in ‘Selective Default’.

And this would ensure the knock-on effects continue.

Global pension funds, central banks, you name it, all invest in American government debt. Many have mandates saying they can only invest in BBB-rated investments and above.

“If America downgrades, many will be forced to sell their US Bonds, and that’ll put upwards pressure on bond yields,” Oliver says. “Interest rates would quickly rise.”

There would be other effects too, some caused by the higher interest rates, and some just by the whole situation. Confidence in America would decline, sending the dollar plunging. Borrowing costs for businesses would escalate rapidly, as many global interest rates are tied to the price of US government debt.

We saw this happen in Europe, Oliver says. “When those countries had debt downgrades, their bond yields went up even before the downgrades occurred. The effect of this was that companies in those countries faced higher borrowing costs.”

Westpac economists Sean Callow and Richard Franulovich wrote yesterday that this’ll keep the American dollar low, which could have positive effects for the Australian dollar. However, they’re not expecting a dramatic change from where it is now.

November 15

Two weeks later, another, far larger interest repayment is due. If a deal still hasn’t been reached, America would default on $30 billion in scheduled repayments, throwing markets further into chaos.

After…

After that, it’s not really clear what would happen. While America could miss a few more payments, it’s unlikely to keep doing so indefinitely, Oliver says.

That’s because America still has trillions of dollars in tax coming in. It will breach its debt ceiling because its budget is not currently balanced. But if it were to pass a balanced budget – one that contains enough money to pay its liabilities while meeting its interest repayments by doing a mix of raising taxes or cutting government services, it could continue to make repayments.

However, this would likely choke off the global recovery, and the upheaval alone would likely be catastrophic for global economic growth.

There’ll be long-term consequences for America as well. The country currently enjoys enormous economic advantages by virtue of being the globe’s economic powerhouse, as well as its reputation for having never defaulted on its debt.

America can borrow more cheaply, it has the world’s most important currency, it’s where successful companies the world-over flock to list.

These and other advantages enjoyed by the American economy would be put at risk if the nation defaulted on some of its repayments.

“We’ve seen what happened to Argentina and Russia when they defaulted,” Oliver says. “It took them a long time to return to where they were. That stigma sticks for a while.

“America lost a lot of face through the global financial crisis. It was seen as having a strong, robust, innovative economy, and then the GFC tore holes through that concept.

“The world is increasingly starting to look towards China, and that comes as a difficult time for America. Another failure here could further accentuate perceptions of its economic decline.”

Back to reality

Ultimately, however, few expect these catastrophic events to come to pass.

“I think this is extremely unlikely,” Oliver says.

“If this does happen, it’ll be because of a miscalculation. At the moment, the main risk is that both sides assume the other will blink. Republicans think even if Obama says he won’t negotiate, he will, and Obama assumes the Republicans will cave in. If those assumptions are both wrong, we’ll have a lot to worry about.”

Overnight in America, Republicans proposed a deal where they would raise the debt ceiling for six weeks in order to negotiate a solution. However, President Obama rejected the deal as it would not re-open the government in the meantime.

Australian businesses with operations in America tell SmartCompany the chatter is that a deal will be reached by Monday. We hope they’re right.