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Ask the Experts: What Will Happen if the U.S. Defaults?

by John S Kiernan on October 16, 2013

us defaultIt has been more than two weeks since the federal government closed many of its doors, sending roughly 800,000 employees home to wait without pay and taking a yet unknown toll on the country’s economic recovery from the Great Recession. During that timeframe, as politicians have pontificated to no end and worried consumers have prepared cash flow contingency plans, we’ve all kept one eye glued to cable news and another focused on the calendar – Thursday Oct. 17, to be specific.

That date has been looming over the debate from the jump, as it represents the time by which the U.S. Treasury will have exhausted its legal borrowing authority and will therefore no longer be able to guarantee its capacity to pay the country’s debts.

We’ve all heard how disastrous it would be for Congress not to raise the debt ceiling by then, but with all of the rhetoric and political posturing we’ve been forced to endure of late, it’s understandably difficult to differentiate fact – or at least well-reasoned likelihoods – from all of the nonsensical chatter.

So, it’s fair to wonder whether or not we should actually be concerned about this man-made crisis point. In other words, is the hype justified this time around or is this simply another case of the boys and girls in Washington crying economic wolf?

WalletHub consulted a number of leading experts in the fields of economics, banking, and public policy for answers to that very question, and the breadth of their opinions spans nearly as far as the political leanings of our country’s leaders.

False Alarm or Recession in the Making?

There is still time for Congress to figure out a funding resolution, but the dangers of not doing so are indeed real. For starters, a U.S. default would lead investors to start asking for higher rates of return on Treasury bonds, which would in turn increase the cost of consumer borrowing – from credit cards to auto loans to mortgages. At a time when the average household owes roughly $6,700 to their credit card company and student loan balances are well over $1 trillion, increased interest rates aren’t something we can really afford.

“If a solution is not found and the Treasury is unable to meet its financial obligations then I expect that interest rates on federal government debt will begin to increase more significantly. If so, it is possible that this might reduce the demand for other types of debt instruments throughout the U.S. and lead to higher interest rates throughout the economy,” said Mark C. Strazicich, a professor of economics at Appalachian State University. “If interest rates rise throughout the economy then borrowing costs would go up for many types of new loans as well credit cards, which would be expected to dampen both business and consumer spending.”

Increased consumer costs aside, a default would be potentially devastating to the United States’ reputation on the world stage, particularly as it relates to the safety of Treasury bonds as an investment vehicle.

“U.S. debt has been THE highly liquid, perfectly safe asset. If we default now, it will never again be perfectly safe,” said Richard Schmalensee, dean emeritus for the Massachusetts Institute of Technology’s Sloan School of Management. “Financial markets built on that safety will be thrown into turmoil. Will it cause another Great Recession? Perhaps. Will it be a disaster for the US and the world economy? Without doubt. This is worse than a third-world government: in third-world countries somebody with common sense and a gun would step in.”

The particularly unnerving aspect of this whole issue is the likelihood that even if we escape danger this time around, any solution that Congress implements will only be temporary and we will therefore have to revisit the underlying economic issues in a few months. By then, the stakes may have only become more significant.

“It might actually be worse the next time,” said Elisabeth D. de Fontenay, an associate professor of law at Duke Law School who studies corporate finance and financial institutions. “A short-term extension would signal that Congress continues to toy with the idea of a U.S. default and – despite all the warnings and market volatility – still doesn’t appreciate quite how serious the situation is.”

Ultimately, it seems that even those who believe not much will come of this particular debt-ceiling scare are of that opinion simply because they consider the potential ramifications of hitting the limit to be too unfathomable for politicians to allow their game of chicken to continue much longer.

“There seems to be enough public disenchantment with both political parties from this shutdown that both parties would find it in their best interest to try to resolve this without any more shocks to financial markets,” said Gordon V. Karels, the Nebraska Bankers Association College Professor of Banking at the University of Nebraska – Lincoln.

Nevertheless, we’ll just have to wait and see how things play out in the next couple of days. It will certainly be interesting, to say the least. In the meantime, if you’re interested in taking a closer look into the cystal ball of our economic future, you can check out our experts’ commentary in full below.

Ask The Experts

  • Just how catastrophic would the federal government defaulting on its loans be for the economy - both in the United States and worldwide? In other words, what are politicians risking here?
  • Does a short-term debt ceiling increase (as was proposed Thursday) simply mean that we will encounter the same market volatility and concern witnessed over the past few of days a month from now?
  • How do you see economic policy taking shape under Janet Yellen? What is the outlook for the economy in the next 3-5 years?
  • What is your take on the government shutdown, the debt ceiling debate, and the state of the U.S. economy more broadly?
  • Do you think that “stimulus” is just a political buzzword that no one wants to go out and say?
  • Do you think that Yellen’s policies will differ very much from Bernanke’s?
  • What is your take on the government shutdown, the debt ceiling debate, and the state of the U.S. economy more broadly?
  • What would happen if the U.S. were to default on its debt obligations?
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  • Richard Schmalensee Howard W. Johnson Professor of Management, Emeritus; Professor of Economics, Emeritus; & Dean Emeritus with the Sloan School of Management at the Massachusetts Institute of Technology
  • Frank Zhang Professor of Accounting at Yale University
  • Art Benavie Professor of Economics at the University of North Carolina, Chapel Hill
  • King Banaian Professor of Economics & Director, School of Public Affairs Research Office at St. Cloud State University
  • Gordon V. Karels Nebraska Bankers Association College Professor of Banking at the University of Nebraska – Lincoln
  • Elisabeth D. de Fontenay Associate Professor of Law at Duke Law School
  • David S. Bates Professor of Finance & the W. A. Krause Faculty Fellow with the Henry B. Tippie College of Business at the University of Iowa
  • Terrence Guay Clinical Professor of International Business with the Smeal College of Business at the Pennsylvania State University
  • Mehmet F. Dicle Assistant Professor of Finance at Loyola University New Orleans

Richard Schmalensee

Howard W. Johnson Professor of Management, Emeritus; Professor of Economics, Emeritus; & Dean Emeritus with the Sloan School of Management at the Massachusetts Institute of Technology
Richard Schmalensee
Just how catastrophic would the federal government defaulting on its loans be for the economy - both in the United States and worldwide? In other words, what are politicians risking here?

US debt has been THE highly liquid, perfectly safe asset. If we default now, it will never again be perfectly safe. Financial markets built on that safety will be thrown into turmoil. Will it cause another Great Recession? Perhaps. Will it be a disaster for the US and the world economy? Without doubt. This is worse than a third-world government: in third-world countries somebody with common sense and a gun would step in.

Does a short-term debt ceiling increase (as was proposed Thursday) simply mean that we will encounter the same market volatility and concern witnessed over the past few of days a month from now?

Precisely!

How do you see economic policy taking shape under Janet Yellen? What is the outlook for the economy in the next 3-5 years?

I do not see her doing things very differently from what Bernanke would have done. If the Tea Party pushes us into recession by forcing a default, she will have to deal with that as he would have done. If sanity prevails, she will gradually take her foot off the economic accelerator as the economy gradually recovers for a few years. The unresolved euro crisis and the slowdown in China and elsewhere, plus problems here at home, argue against a vigorous recovery.

Frank Zhang

Professor of Accounting at Yale University
Frank Zhang
Just how catastrophic would the federal government defaulting on its loans be for the economy - both in the United States and worldwide? In other words, what are politicians risking here?

Not much so. The stock market would have a big hit over short term, say -5% in matter of few days. But then investors would realize this is not a big deal. It’s not the case that the U.S. does not have the ability to pay (unlike Greece). It’s because of the political game in Washington. Stock price will quickly convert to its normal level.

Does a short-term debt ceiling increase (as was proposed Thursday) simply mean that we will encounter the same market volatility and concern witnessed over the past few of days a month from now?

Yes, a short-term deal does not solve the uncertainty. So volatility will stay.

How do you see economic policy taking shape under Janet Yellen? What is the outlook for the economy in the next 3-5 years?

Not much change from current policies. The economy is not going to get much better than today.

Art Benavie

Professor of Economics at the University of North Carolina, Chapel Hill
Art Benavie
What is your take on the government shutdown, the debt ceiling debate, and the state of the U.S. economy more broadly?

We have approached a new normalcy in this country where we have huge unemployment and income that is lower than it should be, and this is not something that can be easily replaced and what we’re doing through our policy just in general, not even just to sequester, is cutting government spending and causing recession to get worse. So it’s a disaster; I mean everything is a disaster. Forget the whole thing about the debt ceiling; the textbook treatment for something like this since monetary policy has pretty much ran out its string is a massive fiscal stimulus and nobody’s even talking about that. I heard Washington Week the other day and the reporters never even mentioned that. That’s the only tool this country has. So, it’s a disaster.

Do you think that “stimulus” is just a political buzzword that no one wants to go out and say?

It seems like it. I don’t understand it. Just talk to any economist, right-wing or left-wing; talk to [Martin] Feldstein on the right, talk to [Paul] Krugman and [Joseph] Stiglitz on the left; they’d all say the same thing. Their personal view would differ as to whether it should be mostly tax cuts or government spending increase, but they all say we need an increase in total spending in the economy and that monetary policy can’t do any more than it has. I mean they’ve done a wonderful job. I think Bernanke has been fabulous, and I think that Yellen is going to be marvelous too.

Do you think that Yellen’s policies will differ very much from Bernanke’s?

I don’t think so. I think they’ve been pretty much together in terms of policy. She’s a first-rate economist and also she realizes that even though the Fed is representing lenders and they are very much against inflation for that reason, that she is perfectly willing to be energetic to bring interest rates down when the economy is having problems generating full employment. So, that’s the main thing. I think she’s not ideological in the sense that she’s not concerned about unemployment and she’s very, very smart.

That’s good news I guess, but you’re saying that a lot of it is essentially out of her hands?

Absolutely it’s out of her hands. There’s not a damn thing she can do now. She can only maintain the low interest rates that she has. That’s all she can do and there’s no more stimulus that monetary policy can give the economy for everything that I know about it. I wish there was. The only tool we have now is fiscal policy and that tool is being used in the wrong direction. It’s very, very upsetting to me.

If things were up to you, what would you do?

What I would do would be to have a massive increase in government spending and some tax cuts on people that will spend the money – a massive increase in the deficit of $400 - 500 billion dollars. This is what we would need to get the economy back to a reasonable unemployment rate. We have the lowest employment-labor force ratio in many, many years. That’s a crucial index. So there are a lot of people suffering and losing their homes and everything else, and we’re not doing a damn thing about it.

That’s the main thing right now: jobs-jobs-jobs. People are out there, they can’t get work. And the government is not only not doing anything about it, it’s aggravating the problem. … The other thing that’s upsetting to me is the long-run. And there I’m upset with my colleagues... because they keep talking about ‘well, we must in the long-run get the debt down,’ and that’s bullshit. I mean, that’s not reasoning; that’s talking about an axe approach. You don’t talk that way; you talk about benefits and costs. And when you’re talking about the long-run and getting the debt down, you’re not weighting the benefits and costs. You have to talk about that and economists are capable of doing it.

You know what bothers me and has bothered me ever since I was a graduate student? Economists have a usual kind of arrogance that when they’re being talked to about policy, they cannot resist saying something they have no right to say. An economist, for example, does not have the right to say ‘we should bring down the debt’ because there are many costs and benefits in doing that and within the field of economics there’s no way to weigh those costs against the benefits. So, as an economist, you can’t make a statement like that.

King Banaian

Professor of Economics & Director, School of Public Affairs Research Office at St. Cloud State University
King Banaian
Just how catastrophic would the federal government defaulting on its loans be for the economy - both in the United States and worldwide? In other words, what are politicians risking here?

The US suffered a default of a few issues of Treasury bills in 1979. According to research done about 25 years ago on that event, the resulting increase in short-term interest rates was 60 basis points. Were all US debt to be re-issued at this higher interest rate, the increase in debt service costs to the US budget would be about $100 billion per year. (The researchers did not find that the increased rates subsided.) That’s one risk. The other risk is if the bonds used as collateral in very short-term credit markets (repurchase agreements, e.g.) was suddenly at risk of default. It is hard to predict the impact of having a market’s collateral suddenly disrupted, and harder still to quantify it. But it would certainly be disruptive.

Does a short-term debt ceiling increase (as was proposed Thursday) simply mean that we will encounter the same market volatility and concern witnessed over the past few of days a month from now?

Market participants learn over time what the result of previously-unconsidered actions are. We have not experienced this degree of disruption in US Treasury debt markets before, so markets are learning what happens as we approach a solution. I expect the next time to be less disruptive than this one.

How do you see economic policy taking shape under Janet Yellen? What is the outlook for the economy in the next 3-5 years?

The FED under Yellen will continue to follow the dual-mandate strategies of Bernanke. She shares his commitment to transparency, so the press conferences and forward guidance policy will both continue. She may be more willing to use rules (versus discretion) than her predecessors. But she will also place more weight on employment and growth concerns than they did. The Large Scale Asset Purchase program (i.e., QE3) will continue into 2014. My short-run expectation is for better growth in 2014, but the drag of higher interest rates that must come as the Fed unwinds QE3, along with slower labor supply growth, will reduce growth over the medium term.

Gordon V. Karels

Nebraska Bankers Association College Professor of Banking at the University of Nebraska – Lincoln
Gordon V. Karels
Just how catastrophic would the federal government defaulting on its loans be for the economy - both in the United States and worldwide? In other words, what are politicians risking here?

A true federal government default would introduce tremendous volatility into bond markets worldwide. That would mean that investors would actually have to take a haircut on their treasury holdings. I don’t see that happening nor is there a reason it would need to happen even if we hit the debt ceiling. Treasury could use cash flows from tax receipts (instead of additional borrowing) to pay off maturing debt. Paying off that debt would allow the government to again borrow up to the debt limit. The size of the public debt could not increase so there could not be any additional borrowing (and hence deficit spending).

Does a short-term debt ceiling increase (as was proposed Thursday) simply mean that we will encounter the same market volatility and concern witnessed over the past few of days a month from now?

Probably not. If Congress can reach some type of compromise for a short-term debt ceiling increase chances are they could and would renew that legislation until they were able to reach a deal on a longer term debt ceiling increase. There seems to be enough public disenchantment with both political parties from this shutdown that both parties would find it in their best interest to try to resolve this without any more shocks to financial markets.

Elisabeth D. de Fontenay

Associate Professor of Law at Duke Law School
Elisabeth D. de Fontenay
Just how catastrophic would the federal government defaulting on its loans be for the economy - both in the United States and worldwide? In other words, what are politicians risking here?

U.S. Treasuries are currently thought to be the only risk-free asset in the world: the rest of the world buys them simply to have a safe place to park their cash. If the U.S. defaulted on its debt, the money flows would start moving in the other direction, meaning that the U.S. would have to pay considerably higher interest rates to attract capital. This would have a massive negative impact on the U.S. economy, with consequences ranging from much lower consumption and higher joblessness to potentially losing our status as the financial center of the world. Most Americans do not appreciate quite how much we benefit from serving as a piggy-bank for the rest of the world.

Does a short-term debt ceiling increase (as was proposed Thursday) simply mean that we will encounter the same market volatility and concern witnessed over the past few of days a month from now?

It might actually be worse the next time, because a short-term extension would signal that Congress continues to toy with the idea of a U.S. default and – despite all the warnings and market volatility – still doesn’t appreciate quite how serious the situation is.

How do you see economic policy taking shape under Janet Yellen? What is the outlook for the economy in the next 3-5 years?

Most observers think that Janet Yellen will continue to pursue a loose monetary policy of keeping interest rates low. The bad news is that this means the Fed thinks the economy will continue to be weak in the near term.

David S. Bates

Professor of Finance & the W. A. Krause Faculty Fellow with the Henry B. Tippie College of Business at the University of Iowa
David S. Bates
Does a short-term debt ceiling increase (as was proposed Thursday) simply mean that we will encounter the same market volatility and concern witnessed over the past few of days a month from now?

Markets have not in fact been particularly volatile during the past weeks, with the VIX only briefly going above 20 early last week. By contrast, the VIX went above 40 during the 2011 fiscal confrontation and the 2010 Greek crisis, and above 80 in the fall of 2008. The options markets seem to feel this confrontation will be resolved uneventfully.

Terrence Guay

Clinical Professor of International Business with the Smeal College of Business at the Pennsylvania State University
Terrence Guay
What is your take on the government shutdown, the debt ceiling debate, and the state of the U.S. economy more broadly?

The government shutdown has put the US in the awkward position of being lectured by other countries, including China, the European Union, and the International Monetary Fund, for being fiscally irresponsible. There has been some movement in the bond market, as central banks have sold some of their inventory of US treasuries. The shutdown has not really affected trade or foreign investment flows, but a prolonged period of inaction could weaken consumer confidence and slow down spending in the critical weeks leading up to Christmas.

An actual default on our debt could lead credit agencies to lower our rating, thereby increasing the cost of government borrowing - a cost that would ultimately be passed on to taxpayers. Countries might also decide to diversify out of US dollar assets, putting downward pressure on the dollar and increasing the cost of imports to the US, perhaps fueling inflation. A default also would weaken our credibility with other countries currently experiencing a financial crisis (think Greece) or may face one in the future (perhaps India or even China). So to a large extent, a default would affect the US more in terms of global politics than economics.

Mehmet F. Dicle

Assistant Professor of Finance at Loyola University New Orleans
Mehmet F. Dicle
What would happen if the U.S. were to default on its debt obligations?

The following is a list that I thought would happen based on my academic and professional banking experience.

1. Treasury needs to borrow everyday to replace maturing debt. That is how the actual default would happen. If Treasury cannot borrow then maturing debt cannot be paid.

2. Treasury prices would plunge. Many banks that hold US treasuries as their cash/marketable securities would become illiquid. They would have to sell their Treasuries at a huge loss which would eat away from their paid-in capitals and eventually they would become undercapitalized. Illiquid bank = bank runs. Deposit insurance can hold-off deposit holders only for a few weeks. One large bank failure, there would be no deposit insurance left. After all, if Treasury defaults, Treasury cannot fund deposit insurance. By the way, this scenario is not just for the US. Almost all international banks keep US Treasuries as their marketable securities since there is no default or liquidity risk. International banking system failure.

3. Many foreign governments keep US Treasuries as their US Dollar reserve. They would have US Dollar cash but US Treasuries would be the major part. When their currencies lose value, central banks would start selling US Dollar and buy their own currency. Significantly lower Treasury prices would lower international US Dollar reserves. In lack of sufficient US Dollar reserves local currencies cannot be defended. More so for emerging countries, people would start demanding traditionally trusted currencies: Swiss, Deutsch, French, British etc. US Dollar value collapse along with emerging economies’ currencies.

4. When US declared the end of Gold standard, US Dollar lost value to say the least. A default on US debt would end the US Treasury standard. World economies depend on US Treasuries in terms of leveraging debt. Many debt issues have US Treasuries as collateral. As the collateral loses value, these debt issues will lose value as well. In case of debt through banking systems, loss of collateral value will result in recall of debt (or portions of them). Collapse of international leveraged debt and credit markets.

5. When banks borrow from each other for short-term, they use US Treasuries as collateral. US Treasuries are also used for short-term repurchase arrangements (loans). Once Treasuries lose value, or their value fluctuates, then most financial institutions will discount the value of US Treasuries as collateral. This will result in lower short-term borrowing capacity for financial institutions. This will be especially the case for large, systemic, financial institutions. LIBOR, PIBOR, TIBOR, etc., markets will collapse and interest rates will jump.

6. Once LIBOR jumps, variable interest borrowing rate will jump as well. Most variable interest borrowing arrangements are LIBOR plus a risk premium. Thus, a jump in LIBOR will indicate a jump in variable interest rates. Variable interest borrowing arrangements include Eurobonds, corporate borrowing, mortgages, consumer credit, credit cards, car financing, clean lines of credit, international trade financing, commercial borrowing, project based borrowing, construction borrowing etc. This may lead to further default: ripple effect. Default would be imminent for foreign governments with high debt, corporations with high debt and individuals with high debt.
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John Kiernan is Senior Writer & Editor at Evolution Finance. He graduated from the University of Maryland with a BA in Journalism, a minor in Sport Commerce & Culture,…
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