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The Risks of Default, Technical Default, and Business as Usual

Monday October 14th, 2013   •   Posted by Craig Eyermann at 7:09am PDT   •  

14544643_SAbout 17% of the U.S. federal government has been shut down since October 1, 2013, and later this week, on October 17, 2013, the U.S. Treasury reports that it won’t be able to continue play its shell game in keeping the U.S. national debt officially below the legal debt ceiling.

In terms of negative impact to the U.S. economy, the partial government shutdown just isn’t that big a deal. However, a default on the U.S. national debt would be.

Keep in mind that there are two versions of default, with one being considerably more catastrophic than the other, but the less severe version would have economically painful consequences.

The catastrophic version would be for the U.S. Treasury to straight up default on making principal and interest payments to the U.S. federal government’s creditors, which is something that could happen if U.S. Treasury officials prove incompetent in prioritizing debt payments after they lose their ability to continue playing the “extraordinary measures” shell games they have played since May 2013. Last month, U.S. Treasury Secretary Jack Lew announced that they would not be able to continue playing those shell games as of Thursday, October 17, 2013.

When those shell games stop, both the U.S. federal government’s credit rating would be negatively impacted and the nation’s creditors, whose lending support nearly one-third of the federal government’s spending, will refuse to loan money to the U.S. government unless they receive higher payments through higher interest rates.

That will negatively affect the entire U.S. economy because of the linkage between the yields of U.S. government-issued securities and consumer interest rates, such as those for mortgages. Similar linkages would also negatively affect stock prices, which would negatively impact retirement and other investment accounts during the period in which the U.S. government would be in default.

Beyond that, when the U.S. government is forced to pay higher amounts of interest to its creditors, a greater share of the U.S. government’s budget will have to be devoted to making those principal and interest payments, meaning that U.S. politicians will either have to cut spending or borrow an increasing amount of money to sustain their desired level of spending.

Keeping in mind that the reason we’re even having this discussion now is because U.S. politicians have almost invariably chosen to borrow more, rather than to cut spending. What that scenario sets up is the national debt death spiral, much like those that have occurred in Greece, Spain, and Argentina. The U.S. Congressional Budget Office has already projected that this scenario will play out, even without any partial government shutdown or catastrophic default taking place:


And that’s even in the best case scenario, which assumes that both Medicare and Social Security benefits will be reduced when the trust funds for each are depleted, beginning in 2016 for Social Security’s disability benefits, and in 2026 for Medicare and 2033 for Social Security retirement benefits.

The good news is that U.S. markets have thus far indicated that there is little probability of that catastrophic scenario playing out, which only would if the Obama administration proves unwilling or incompetent in prioritizing principal and interest payments to the U.S. government’s creditors. Instead, if the budget and debt debate is not resolved prior to the targeted end date of the U.S. Treasury’s shell games on October 17, 2013, it is more likely that the U.S. government will only “technically” default on its obligations.

In this situation, the U.S. Treasury would keep paying the principal and interest owed to those who have loaned money to the U.S. government, thus avoiding the catastrophic version of a national debt default, but not make other payments to the government’s various vendors, suppliers and contractors. In that situation, the U.S. federal government would be forced to reduce its spending by an estimated 32% below its average level of $3.6 billion per day, as it would instantly be forced to operate with a balanced budget.

That’s a more serious amount of money than that associated with the partial government shutdown. If continued for a prolonged period of time, such a reduction could force the U.S. economy into recession.

Here, the good news is that the Federal Reserve’s current quantitative easing programs will offset a good portion of the negative consequences of that outcome, but only a portion. The Fed could fully offset that impact through its monetary policies if it chose to expand its quantitative easing programs, which it might consider for the sake of compelling those U.S. politicians seeking political profit from imposing economic pain upon regular Americans to instead adopt more fiscally sustainable spending levels by breaking their ability to cause such unnecessary hardships.

The question that needs to be answered by U.S. politicians at this time is whether it is worth the short-term economic pain and potentially higher borrowing costs in the future to address the nation’s longer-term problems, where both the pain and penalties will be even greater if they fail to address the federal government’s unsustainable level of borrowing and spending by allowing U.S. politicians to continue business as usual.

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October 2013