Consequences of defaulting on the federal debt

Posted by AzBlueMeanie:

Congress has the duty to honor the debts of the United States by raising the federal debt ceiling under the "full faith and credit clause," Article IV, Section 1, of the U.S. Constitution, and Section 4 of the 14th Amendment to the U.S. Constitution. Not raising the federal debt ceiling will cause a default on the U.S. debt in violation of the U.S. Constitution.

Has the U.S. ever defaulted on its debt? Well, in a technical sense yes, briefly and unintentionally when Congress waited to the last minute to act to raise the federal debt ceiling in 1979. Our present situation differs where Tea-Publicans are threatening not to raise the federal debt ceiling intentionally to put the nation's debt into default. That will shake the confidence of the international markets in the ability of the U.S. government to govern itself and to honor its debts. Delayed payments in 1979 offer glimpse of default consequences – The Washington Post:

In fact, there was one short-lived incident in the spring of 1979 that offers a glimpse of some of the problems and costs that might arise if the stalemate on Capitol Hill continues. Then, as now, Congress had been playing a game of chicken with the debt limit, raising it to $830 billion – compared with today’s $14.3 trillion – only after Treasury Secretary W. Michael Blumenthal warned that the country was hours away from the first default in its history.

That last-minute approval, combined with a flood of investor demand for Treasury bills and a series of technical glitches in processing the backlog of paperwork, resulted in thousands of late payments to holders of Treasury bills that were maturing that April and May.

“You hear lot of people say, ‘The government never defaulted.’ The truth is, yeah, they did . . . It might have been small, it might have been inadvertent, but it happened,” said Terry Zivney, a finance professor at Ball State University who co-authored a paper on the episode entitled “The Day the United States Defaulted on Treasury Bills.”

All things considered, the incident amounted to a minor blip. The Treasury had missed payments on about $120 million worth of bills, a tiny amount even then, given the global investment in U.S. debt. Investors, some of whom joined a class-action suit against the government to recover damages, eventually were paid in full with back interest. T-bills, as they are known, continued to be considered a safe investment. Treasury officials both then and now argued that the event was not even a default, but merely a delay caused by the internal logjam.

“It was quickly forgotten,” said Jim Angel, a finance professor at Georgetown University.

And yet, the study by Zivney and his partner, Dick Marcus, found that even that brief failure to meet some obligations had expensive consequences. The pair concluded “that the series of defaults resulted in a permanent increase in interest rates” of more than half a percent, which over time translated into billions of dollars in increased interest payments on the nation’s debt, a cost shouldered by taxpayers.

“The impact is smaller at first because only new debt is affected,” they wrote. “But over time, as the older debt matures and becomes refinanced at higher rates, the entire cost of the default is realized.”

Zivney said that the 1979 incident, which pales in comparison to the size and scope of payments the Treasury could have to forego if it can no longer borrow money come Aug. 2, offers a useful case study in the real-world consequences that result when the U.S. government doesn’t seem like the sure bet it has always been.

“It creates doubt, and I think that’s the real lesson,” he said. “The market has a much longer memory than individuals.”

Angel, the Georgetown professor, said that the surest way to stave off any such doubts is for Congress to find a way to set aside political fights long enough to ensure that the country continues to pay its bills. Otherwise, he said, investors will punish the United States – and ultimately taxpayers – if and when checks stop showing up.

Ezra Klein posts today Defaulting on the debt would return us to recession:

On Friday’s edition of the “Martin Bashir” show, Jay Powell, who’s conducted the most thorough study of the aftermath of a debt default, gave me a number I hadn’t heard before: $134 billion, or 10 percent of August’s GDP.

That’s the size of the economic hit we’ll take if the debt ceiling isn’t raised and the federal government has to slash spending by 44 percent for the month of August. If it continues through to September, well, that’s even worse.

Even without accounting for the knock-on effects of uncertainty in our political system and chaos as the Treasury Department tries to figure out how to cut federal spending in half, that’s more than enough to tip us back into a recession.

Jay Powell served as undersecretary of the Treasury in George H.W. Bush’s administration. His analysis for the Bipartisan Policy Center says that if the debt ceiling isn’t raised by Aug. 2, the Treasury Department is going to have to figure out which 30 million of those bills should go unpaid. What failure to raise the debt ceiling will look like:

The paper lays out a few scenarios for how that might go. In the “Protect Big Programs” scenario, Treasury pays bills related to interest on the debt, Medicare and Medicaid, Social Security, defense suppliers and unemployment insurance. That means it stops paying military salaries, gives up on the FBI and the Centers for Disease Control, cuts all funding for food stamps and education, shuts down air control, tells NASA to head home, freezes the paycheck of every federal employee, and much more. In another, the Treasury Department tries to protect the social safety net, but has to stop supplying the troops, sending out tax refunds, inspecting offshore oil rigs, etc. 

This also leads to an extraordinary assertion of executive power. The executive branch carries out the laws enacted by Congress. Asking them to “prioritize” across different spending needs is asking them to selectively decide between different laws that Congress has passed. 

Since the Treasury has never had to make these decisions before, no one quite knows how they’ll be made.

* * *

According to the BPC’s calculations, the federal government needs to roll over $500 billion of debt in August. If we’re in quasi-default, who will want to purchase that debt? What will they charge us when they do purchase that debt? A 10 percent premium would cost us $50 billion. A one percent premium would cost us $5 billion. And that’s only the direct cost. Because so many other kinds of debt benchmark against the rates the Treasury pays, you’ll see borrowing costs rising throughout the system. Mortgages, corporate borrowing, all of it. It won’t just be the federal government that pays. It’ll be the economy.

All lending agreements, whether between central banks of countries, or your mortgage or credit card agreement, have a "default" provision that automatically escalates the rate of interest to a default rate in the event of default. For many, this will affect your credit worthiness and make credit unavailable. The banks will "adjust" the interest on all credit agreements. Default will cost Americans hundreds of billions of dollars in additional interest and tax dollars to finance the interest on the federal debt over time.

So when you hear the darlings of the Tea Party like Sen. Jim DeMint (R-SC) and Rep. Michele Bachmann (R-MN) say they are going to vote against raising the federal debt ceiling because they "don't believe" anything bad is going to occur, just keep in mind that they are ignorant of history, ignorant of economic principles, ignorant of how the international monetary system works, and ignorant of how international markets work in the real world.

Why would any sane person listen to what an ignorant fool has to say when all the experts in the field who do this for a living say it will result in a debt crisis and another recession?