The Question No One Wants to Ask: What Would Happen if the US Government Defaults on Its Debts?

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Dow falls 777 points, biggest one-day drop ever

With debt ceiling talks completely stalled and neither side wanting to give up political ground, the United States faces a true possibility of default for the first time ever. And the news coming out of Washington is less than stellar. In fact, its downright scary.

Stan Collender, budget expert at Qorvis, spoke to Ezra Klein in Sunday’s Washington Post. He ominously explained,

 “[There is] less than 50-50 [chance of a deal before Aug. 2]..." 

And David Cote, chairman and CEO of Honeywell, on the “Meet the Press” roundtable commented,

 “[I]t's like both parties have a grip on each other's throat and they're more focused on simultaneous asphyxiation than they are on actually resolving the problem.”  

Finally, The New Yorker’s George Packer:

“Obama and Congress are engaged in high-drama brinksmanship, like members of an ordnance-disposal unit arguing about how to defuse a huge ticking bomb.” 

Hearing these types of words form high-level officials and commentators this late into the debt ceiling discussions is extremely disheartening and worrisome for the economic fate of the nation. Remember, while the Obama Administration has said that we will begin the process of defaulting on our obligations August 2nd, it takes time for a bill to be drafted, debated, and passed in both the House and the Senate. If we are going to reach a deal before the deadline, it will have to come this week.

Google Images: On September 29, 2008, the Dow Jones Industrial fell 777 points, the largest single-day drop in history. Analysts are speculating that if a deal is not reached by August 2nd, we could see something comparable, if not worse, to the economic collapse of 2008.

The Current Situation 
Let's face some unfortunate facts:

• The President of the United States and high level treasury officials say that we have until August 2nd at the latest to increase the debt ceiling
• Republicans in Congress are refusing to accept any form of tax hike on any person or corporation (this includes eliminating loopholes for big oil, timber, and corporate jet owners)
• Democrats in Congress are refusing to vote for any debt increase if the deal includes cuts to medicare and/or social security
• To make matters worse, Republican have made a far-right turn, pushing a radically partisan "cut, cap, and balance" plan instead of compromising just two weeks away from a possible default. 
• Debt talks have stalled, with neither side ceding any ground; in fact, both sides have apparently dug in

Politicians in Washington are certainly playing with fire when it comes to the debt ceiling. But the American public is not making it any better. Still, despite all the dire warnings, a plurality of Americans believe that the debt should not be raised. As I have previously said, Republicans see a political victory out of this, attempting to come down on the side of the people since they know that strict opposition to the debt ceiling increase could score them political points now and mean campaign contribution for their 2012 war chest. But maybe, just maybe, if I can explain what would happen if we did default, I can begin to change some minds.

What Is A Default?

Default is a relatively simple concept: It occurs when a debtor (in this case the United States) has not met its legal obligations according to a debt contract. This may mean not making a scheduled payment, violating some condition of the contract, or being unable to pay back the loaned money. Default occurs if the debtor is unwilling or unable to pay their debt.

Google Images: Rioting in Greece

If the United States Defaults...

widespread panic would ensue. No country the size of the United States has ever defaulted on its debt. Think about this: The financial markets lost tremendous amounts of value when Greece was seen as a major threat to default in 2010. Greece has a GDP of $329.9 billion. The United States? Our GDP is almost 43 times bigger than that, valued at an astounding $14.12. A number of economists believed that the world economy was in danger of collapsing had Greece defaulted. Now, can you possibly imagine what would happen if the United States defaulted on its debt? 

One thing that is important to remember is that the debt is not just simply a bunch of numbers; it is real money that has been lent to us by foreign countries with the actual expectation that we return that payment plus interest. The debt is owed to foreign countries, multinational banks, and many Americans through the buying of treasury bonds (which are rated as AAA, the safest type of investment money can buy). If, for example, I overspend and am forced to default on my debts that I owe, that money that I owed does not just magically vanish into thin air. The bank is forced to take the loss. The same can be said for the United States of America. If the US was to default on its debt, the rest of the world would suddenly be left with $14 trillion of unpaid liabilities. One can only imagine the catastrophic collapse that would ensue. While we do not know exactly what would happen (since we have never actually been through and never should have to go through it), it is fairly easy to make some well-supported assumptions:

skiddish and more worried. However, if previous experience serves as a guide, we will not see any type of collapse until August 2nd if a deal had not been reached. That being said, if wall street spent months expecting a late-term deal and no deal ultimately gets done, the markets reaction will be uncharacteristically harsh and never-before-seen. Collender explains it best:

[R]emember the general idea on Wall Street right now is that there will be a deal because there’s always a deal. But Wall Street works off of expectations. So if the market realizes they got this wrong, the reaction could be larger than expected. 

The only positive to a market collapse would be that it would most likely force lawmakers to pass a debt increase as quickly as possible. The AP speculates,

The widespread selloff that might trigger could have one benefit, Briggs and others say. Panic-selling might force Washington to quickly agree to raise the debt limit. Think back to September 2008 for some historical perspective. After the House of Representatives voted down the bailout bill to create the Troubled Asset Relief Program on Sept. 29, the Dow Jones industrial average nosedived 777 points. Congress made an about face and four days later passed the TARP bill. President George W. Bush quickly signed it into law.

But even then, one day past August 2nd is one day too many. A deal is easily reachable if both sides share the sacrifice. In the end, no one will be happy with the deal that is reached. Ultimately it is about making sure that both sides feel equally bad about the bill that they end up passing.

2. Many of the world's largest banks, who have still not fully recovered from the 2008 financial meltdown, would be forced to go bankrupt to their exposure to United States debt. Subsequently, credit for necessary things like homes, cars, etc., would become almost completely unavailable. Additionally, since many large corporations rely on short-term credit to pay their employees and that credit would all but disappear, many workers would be unable to collect their paychecks. 

Moreover, the credit rating agencies like Moody's and S&P have threatened to downgrade treasury bonds from their AAA rating if a deal is not reached. This would mean that treasury bonds would no longer be considered as safe an investment as they once were and countries like China (who are the biggest buyer of US treasury bonds) would pull out its money and look for a safer investment. This could not only cause short-term economic pain, but have grave, long-term consequences for the United States and the rest of the world.

3. To go along with that point, businesses would begin laying off more workers since they have no access to credit and no way to advance their own growth. With no access to capital, companies would start shedding workers at an alarming rate. This would of course only make matters worse, resulting in at  best a deep recession and at worst another Great Depression. 

4. The dollar would also likely become almost worthless since the "full faith and credit" of the United States is the only real thing holding up the value of the dollar. When that disappears as access to credit vanishes, it is hard to imagine the dollar being able to retain any of its value.

5. The government would also be potentially unable to send out checks for medicare and social security, leaving hundreds of thousands of seniors who rely on medicare for their medications and prescriptions paying extremely high prices.

**There are a whole lot of other things that I could list off, like rising oil prices and subsequently, skyrocketing gas prices. But I think that the above four are the most significant and vital to understand. 

Google Images: Unemployment Could Skyrocket to Numbers Not Seen Since the Great Depression

Conclusion
So will the United States default on August 2nd? Most likely not. While the Treasury has said that August 2 is the drop-dead date for default, economists are saying that if lawmakers were to shut down a large percentage of government agencies and shuffle some money around, a full out default could likely be avoided for a few weeks. Regardless, the prospect of living with 20+% unemployment, no access to credit, a withering stock and mutual fund portfolio, and a global meltdown, is something that no person wants to see.

There is something that every American needs to realize: At this moment, the United States can still easily meet its debt obligations. Ignore the hype, those who say that America is broke and/or out of money are lying to you. 

If the United States goes into default, it will most certainly not be because of the economics. If the US defaults on its own debt obligations, it will be solely due to the politics behind the issue. The unintended consequences of political pandering to pick up votes in 2012 would have such grave economic repercussions that America would be left reeling for years to come.