George Pennacchi is a U. of I. finance professor who studies financial institutions and the bond markets. He discusses the debt-ceiling crisis with News Bureau Business and Law editor Phil Ciciora.
If we don’t raise the debt ceiling by Aug. 2, what’s the worst that could happen?
Currently, the difference between the federal government’s spending and its revenues requires that it borrow almost 44 percent of its spending. Of course, each time the government borrows more, its outstanding debt rises. The total amount of federal debt is expected to hit the legislated ceiling of $14.29 trillion in early August. Thus, if the ceiling is not raised by about Aug. 2, spending will have to be cut by almost 44 percent, down to the level of revenues, which are mostly tax receipts. Then, the U.S. Treasury will be forced to prioritize which spending commitments get paid.
I would speculate that the Treasury would continue to pay interest on Treasury securities to avoid defaulting on its existing debt. Also, it would have enough revenues to pay Social Security, Medicare and Medicaid, unemployment benefits, as well as active military duty pay. Those would soak up about 83 percent of revenues. The remainder could pay only about 18 percent of all other federal spending, including defense contractor payments, federal employee salaries and benefits, IRS refunds, and all other veterans, education, agricultural, commerce and housing programs.
In my view, the worst-case scenario would be if the Treasury decided to stop paying interest on Treasury securities – that is, to default on its Treasury bonds, notes and bills. Potentially, such a default could lead to a financial market panic if investors decide to withdraw their savings from financial institutions that hold Treasury securities, such as money market mutual funds.
It is possible that this scenario could lead to a chain-reaction of financial institution failures as even some non-Treasury securities may lose value if institutions need to sell other securities to pay investor withdrawals that they would normally pay with Treasury interest. Financial markets could freeze up, perhaps even worse that what happened after the Lehman Brothers bankruptcy in September of 2008.
The U.S. dollar would likely suffer a substantial decline in value relative to other currencies as foreign investors lose confidence in Treasury securities.
What’s going to happen with the markets? What kind of losses can we expect to see?
The likely scenario is, the Treasury would continue to pay interest on its securities, but the federal government would be shut down and its other bills would not be immediately paid. The extent of financial market losses would depend on how long it would be until the debt ceiling is raised. Delay of payments to federal government contractors could lead to disruptions and the suspension of government-financed projects. In addition to furloughs of government employees, there would also likely be an increase in private-sector layoffs that would reduce spending and firms’ sales. An expected decline in firms’ profits would lead to significant stock market losses if investors viewed the stalemate on the debt ceiling as continuing for some time.
Failing to raise the debt ceiling will no doubt hurt Wall Street, but how would Main Street share in the pain?
Corporations and small businesses that depend on federal government payments would be hurt, as would be their employees. Others who depend on federal government services and payments (visitors to National Parks, recipients of veterans’ services, education grants, food and nutrition services, housing assistance) may also suffer.
Given what happened with earlier federal government shutdowns, I expect that there would be a public outcry that pushes Congress and the president to finally agree to raise the debt ceiling.
What’s the best that we can hope for right now?
The best-case scenario would be if an agreement is reached on or before the federal government hits the debt ceiling, and the agreement includes a credible commitment by the government to reform its fiscal affairs in a way that significantly lowers the long-run projected debt of the United States. Such a reform is necessary for the U.S. to continue to roll over its debt at low interest expense.
A rise in the debt ceiling without a plan to lower future deficits may only delay an even worse crisis similar to what Greece currently faces.
