Even if a comprehensive agreement to achieve fiscal sustainability is out of reach right now, lawmakers must not go over the debt-ceiling cliff. Without an increase in the ability to borrow, the federal cash flow might be sufficient to make timely debt payments, but what of the government’s countless other obligations? And credit-rating agencies are nervous that Treasury wouldn’t even be able to make debt payments a priority; Moody’s, my employer, just put U.S. debt on review for a possible downgrade.
Defaulting on the nation’s debt would be cataclysmic. The U.S. Treasury’s Aaa rating is the one constant in the world’s financial system. When times are bad anywhere on the planet, global investors flock to Treasury bonds because they know they will get their money back. This “flight to quality” has pushed U.S. interest rates to near-record lows and has been vital to keeping our economy afloat. Yet this benefit was earned over more than two centuries by adhering to the bedrock principle that the United States always pays its bills on time. One misstep, and the government would have to pay higher interest rates for years, perhaps for generations.
Even if Treasury was able to put debt payments at the top of its priority list, the government would come up well short on its other obligations. The shortfall in August alone would approach $150 billion. Government employees could be furloughed, unemployed workers might not receive full benefits, and even Social Security recipients and veterans could come up short.
Though in this scenario there would be no U.S. debt default, stock and bond markets would still react harshly. Cracks are already developing in the market for credit-default swaps on Treasury bonds, where investors buy insurance in case of a bond default. If there is no progress on the debt ceiling in the coming week, more rating agencies will act, and these cracks will turn into fissures.
If spending cuts began in early August, global investors would question the security of their bonds as they saw even Social Security recipients going unpaid. We may have a rerun of the TARP moment in September 2008, when the House initially voted down the bank bailout fund and stock prices plunged. At the very least, stock markets and the value of the dollar would fall sharply and interest rates would spike if the deadline for raising the debt ceiling was missed.
Turmoil in the financial markets, along with draconian cuts in government spending, would sink the fragile economic recovery overnight. There is no way the private sector could fill the gap created by such a sharp pullback in federal outlays. With such a diminished economy, tax revenue would suffer and demands on government support programs would increase, worsening the nation’s fiscal situation. Instead of needing $4 trillion in deficit reduction over 10 years to achieve fiscal sustainability, we would require something closer to $5 trillion. And unemployment would again reach double digits and remain stuck there for at least a couple of years.
It is hard to imagine that political leaders and policymakers would dare go down this dark road. So I expect that they will find a way to increase the debt ceiling on time. If they also figure out how to even partially address our long-term fiscal problems during their negotiations over the next couple of weeks, that would be a big plus. But it is not necessary right now. That’s what the 2012 campaign will be all about.
Mark Zandi is the chief economist at Moody’s Analytics and the author of “Financial Shock: Global Panic and Government Bailouts — How We Got Here and What Must Be Done to Fix It.”
Read more about how a U.S. default would affect
politics and American power abroad.
Read more from Outlook, friend us on Facebook, and follow us on Twitter.