What Happens if the U.S. Defaults on Its Debt?

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One of the fiscal ideas floating around recently, championed by Ron Paul, the well-known Texas Congressman and Republican presidential candidate, is that the United States should “declare bankruptcy” and begin defaulting on some of its debt. This comes as the debate in Congress over whether or not to raise the debt ceiling rages – mostly acridly along party lines. Treasury Secretary Timothy Geithner predicted that the U.S. government can meet its obligations until August 2, 2011, thanks to some creative accounting. Once that deadline passes, he predicts, the government will begin defaulting on its debt.

What Happens if the Debt Ceiling Isn’t Raised?

When countries default on their debts, it doesn’t work the same as when individuals declare bankruptcy. In many cases, the default results in restructuring, and the debt is repaid over a longer period of time, or new terms are hammered out, or some of it is forgiven (but this doesn’t happen much for wealthy, developed nations). What really happens when a country defaults on its sovereign debt is that confidence in that country’s assets is reduced.

In the Wall Street Journal, two economists at UBS Investment Bank shared some insights into what they think could happen if Congress refuses to raise the debt ceiling:

The main impact on markets would come from sharply reduced liquidity in the U.S. Treasury market, as financial firms’ procedures and systems would be tested by the world’s largest debt market being in default. …

All the legal commitments and limitations in a complex financial system mean a shock from an event that is viewed as inconceivable – such as a U.S. Treasury default – can cause the system to stall. …

[I]f the political impasse continues and the U.S. defaults, it would not simply be a question of whether Treasury investors would get their money; eventually they would. It would be a question of whether the U.S. would lose something that made it special. The answer would be yes and the consequences for U.S. growth could be significant.”

U.S. economic growth could see even more issues, and the U.S. bond market, and the U.S. stock market could experience severe problems. Not only that, but the U.S. would lose its credit rating. Indeed, Standard & Poor’s is threatening to cut the U.S. credit rating to a D if the debt ceiling isn’t raised, according to the Financial Times. That’s a long way to fall, and it would mean that rates on U.S. Treasury bonds would head higher, meaning that the U.S. government would have to pay more in interest to those willing to borrow. Plus, the U.S. would no longer be seen as the most stable place to park the world’s assets. Some are even going so far as predict that the default could mean a loss of faith in the dollar to the point that movement away from the greenback as the world’s de facto universal currency would gain true support, rather than the posturing that is the main feature of such suggestions right now.

But How Can We Fix the Nation’s Spending Problem If We Keep Raising the Debt Ceiling?

If we want to maintain the good name of the U.S. in global fiscal circles, and if we want to prevent another global financial meltdown, many believe that the debt ceiling needs to be raised. On the other hand, though, there are those that point out that raising the debt ceiling will only encourage more of the same poor decisions that got us in this mess to begin with. Where do we draw the line? We have to stop the insanity somewhere.

This is why some politicians are insisting that budget reform be part of the legislation needed to raise the debt ceiling. But it might be too late for spending cuts to make a real difference in our government’s spending problem. Some argue that revenue increases are needed as well. Yes, spending needs to be cut. But our problem is so severe at this point that taxes need to be raised as well.

The main argument on one side is that serious spending cuts could solve the deficit problem. On the other side, the argument is that raising taxes is the solution. Very few are willing to say that the pain has to come from both ends: Programs need to be cut, and taxes need to be raised. It’s not fun, but in the U.S., politicians have been content to spend and spend – and voters have been largely content to let them.

Raising the debt ceiling won’t fix the fiscal irresponsibility that has become part of Washington culture. It can only keep the U.S. from losing face before the world (although there is some truth to the argument that we already have), and it will keep the U.S. stock market and the global economy from collapsing in despair. But it won’t solve our country’s financial woes. Long-term solutions have to include better spending habits going forward, and will most likely require higher taxes – at least on the wealthiest individuals and corporations (which are raking in record profits in spite of difficulties many small businesses and individuals are still facing).

A Wake Up Call – And An Opportunity

There are those that view the current situation as a wake up call with an opportunity. It is clear that the fiscal policies adopted by both parties over the past few decades are irresponsible and unsustainable. The current debt ceiling crisis is a chance for us to recognize that and wake up and actually do something about it. It is an opportunity to open debate about national priorities, and what we want to spend money on as a nation (assuming we can do this in a civilized manner). It is also an opportunity to have a meaningful debate about the tax system. Our current system hasn’t been working very well. Could it be time to truly consider the merits of a flat income tax? Or perhaps to consider a consumption-based tax instead of focusing so much on income? There are a number of alternatives that could be considered.

The real question is this: Are we willing to wake up and make painful changes? Or will we simply go on as before, until there is no stopping the complete collapse of the system?