In the early 20th century, Venezuelan dictator Cipriano Castro liked to borrow money from foreign investors. But he didn’t like paying them back. Big mistake. In December 1902, Britain, Italy and Germany demanded repayment. To make the point clear, warships from all three nations shelled several Venezuelan forts and blockaded the country’s ports. Caracas paid up.
Should Washington fail to raise the debt ceiling by Aug. 2 and thus risk defaulting on its financial obligations, the White House and Congress thankfully would not have to worry about gunboats from Europe — or, given who buys U.S. Treasurys these days, from China — appearing off America’s shores. Defaults get more civilized treatment these days: Bond downgrades, panicked market sell-offs and emergency meetings of central bank officials have replaced naval bombardments and threats of war.
Nonetheless, a default could still inflict significant — and wholly unnecessary — harm to America’s ability to wield and project its power in the world. At a minimum, by driving up the government’s borrowing costs, it would intensify pressure to cut defense spending at a time when the U.S. military is engaged in major operations across the planet. Meanwhile, America’s adversaries would cheer Washington’s unforced error as proof of their narrative that the United States is a fading power.
The precise consequences of a default would depend in part on how it happened and how long it lasted. Although few remember it now, the United States had a brush with debt default in 1979. Back then, the Carter White House and Congress took so long to strike a deal on raising the debt ceiling that the government was late in paying holders of Treasury bills.
The world might again shrug off a similar “technical default” in 2011, but one lasting several weeks or longer would be new territory for an advanced Western democracy. In the seven decades since World War II, no such country has defaulted on its debt. Russia defaulted on its loans in 1991 and again in 1998, but at the time, its economy was struggling to make the transition to capitalism, and its international clout had long been in decline.
In short, we are in uncharted waters. No Western major power in recent memory has taken a manageable fiscal problem and turned it into a crisis.
So what is likely to happen? A sustained default could undercut American power in four ways. The first and perhaps most certain would be to force cuts in defense spending. Luring lenders back to Treasury’s auction window would require offering higher interest rates. It is estimated that the 1979 technical default pushed up the federal government’s borrowing costs by about half a percentage point for much of the next decade.
A half-point increase may sound like small change, but spread across trillions of dollars in debt, it is big money. The Congressional Budget Office reported in February that raising interest rates a third of a percentage point over its base-line estimate could add $1.1 trillion in additional interest expenses over the next decade, if the interest rate environment mimics that of the 1990s. Different assumptions would lead to a higher or lower projection, but all predict a bigger burden on the federal budget.