U.S. Debt Default

Every time the U.S. approaches the debt ceiling, investors wonder whether the U.S. will default on its debt. It is unlikely that the U.S. would default, because it has so many other options AND the consequences would be unthinkably dire. However, now that runaway deficit spending has increased the federal budget deficit and debt, and as the debt approaches 100% of GDP, the consequences of a debt default need to be looked at more seriously.

There are two scenarios under which the U.S. would default on its debt. This first would happen if Congress didn't raise the debt ceiling. In a letter to Congress, Treasury Secretary Tim Geithner outlined what would happen:

• Interest rates would rise, since "Treasuries 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 Treasuries. The dollar would lose its status as a global world currency.
• 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.

For all those reasons, the debt ceiling is usually raised.

However, what if the U.S. Government simply decided that the debt was too high, and simply stop paying interest on Treasury bills, notes and bonds? In that case, the value of Treasuries 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 Treasuries in its auction, so the government would no longer be able to borrow to pay its bills. In other words, any default on Treasuries would have the same impact as the debt ceiling crisis.

Even if investors only think the U.S. could default, the consequences could be nearly as bad as an actual default. That's because U.S. debt is seen worldwide as the safest investment anywhere. Most investors look at Treasuries as if they were 100% guaranteed by the U.S. government. Any threat of a default could cause debt ratings agencies, such as Moody's and Standard and Poor's, to lower the credit rating of the U.S.

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." The Dow dropped 200 points and gold gained $10 an ounce in response.

A U.S. debt default, or even a debt downgrade, would significantly raise the cost of doing business. It would increase the cost of borrowing for businesses, who would have to pay higher interest rates on bonds to compete with the higher interest rates of U.S. Treasuries. All interest rates in the U.S. would rise, increasing prices and contributing to inflation. The stock market would also suffer, as any U.S. investment would be seen as riskier. Stock prices would fall as investors fled to other countries' "safer" stocks or gold. It could lead to another recession.

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. However, now that the debt is nearly 100% of GDP, 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 is doing this by monetizing the debt. This means it is buying Treasuries with credit it creates itself. Default can be avoided if the Fed doesn't require the interest to be repaid.

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% in one week. This 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.

However, since the U.S. debt is so much larger than that of either Iceland, Dubai or Greece, a U.S. debt default would have a more negative impact on the global economy. (Article updated August 3, 2011)