Economy

What Happens if the Debt Ceiling is Not Raised?

October 13, 2013

The U.S. Treasury defines the debt ceiling or limit as “the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments.” The current debt ceiling is set at $16.7 trillion. Increasing it is necessary to allow the government to continue to meet its existing financial obligations–it does not give the government free reign to increase spending.

The Republican opposition to setting the new debt limit has already led to a government shutdown, the 18^th in the nation’s history. The shutdown that began Oct. 1 has had numerous repercussions: national park systems are closed, government data reports are not getting compiled or published, certain licensing for imports and exports is delayed, federal employees are not getting paid, the International Trade Commission is not reviewing trade infringement cases … the list goes on and on. Uncertainty makes the stock market unsteady and GDP falls .15 percent every week the shutdown continues according to Morgan Stanley.

If the U.S. should default on its financial obligations the country can expect catastrophic effects say most economists. Payments would be stopped or limited for Social Security and Medicare, military salaries, tax refunds, interest on the national debt, etc. Federally sponsored programs in education and research would disappear. Interest rates could soar. The economic growth that the U.S. is experiencing could stall or even tip the country into another recession.

And a major worry is that the United States credit rating could be downgraded, shaking global confidence in America’s economic standing in the world.

The doomsday date for the country’s first default is October 17.

The debt ceiling deadline of Oct. 17 is not when the US government runs out of money but it is the date when “extraordinary measures” (i.e., accounting adjustments) to fund the government run out along with the Treasury’s ability to borrow more funds, leaving approximately $30 billion in cash on hand. Analysts project $30 billion will only cover bills until November 1. It is after the cash runs out that the government would actually default on its financial obligations.

There is a last resort to avoid default. Morgan Stanley sent its shareholders the following explanation of what the government could do to stop default should Congress fail to raise the debt ceiling:

If the Treasury is unwilling to stretch the definition of extraordinary measures, on the day that the Federal Reserve predicts that the Treasury will run out of cash in its account and the Treasury is bound by the debt ceiling, it should pend all payments and await instructions from the Treasury. As a result, all principals will face the prospect of violating one of three laws:

The Second Liberty Bond Act of 1917 that establishes the debt ceiling;
The Federal Reserve Act that prohibits the Fed from lending directly to the Treasury; or,
The 14th Amendment of the Constitution that holds that the debt of the US government, lawfully issued, will not be questioned.

They have to break a law. Full stop. We think at the end of the day officials will avoid violating the Constitution by indicating that they have been given inconsistent instructions and are obeying the one with the most important precedent.

If it is the Secretary of Treasury that decides to contest 1, then the Treasury will issue debt and raise cash. However, the debt arguably does not have the protection of Amendment 14, as it was not necessarily lawfully issued, so it may not be default free. That is, in the European context, the Treasury will issue “red” bonds in order to pay the maturing principal and interest on “blue” bonds. The reds turn blue when the debt ceiling is increased.

If it is the Chairman of the Federal Reserve that decides to contest 2, then the Treasury General Account (TGA) goes into overdraft and all Treasury operations continue.

Either a Secretary of Treasury who holds 3 as the overriding instruction or a Chairperson of the Federal Reserve who waves 2 saves the global financial system and at most risks being impeached or fired. That seems like a reasonable risk and reward trade-off. The government of the United States is not going to default.

Most Americans want to agree with Morgan Stanley–it seems unthinkable that US legislators would allow the country to default. Negotiations this weekend appear to be moving in a positive direction but it remains to be seen if a deal can be ironed out before Thursday’s deadline.