A default on the country’s debt could cause ‘real and lasting’ damage

The nation's politicians are considering a voluntary default on the country's debt. Yes, "voluntary." The nation's elected leaders in Congress and the White House could end this today if they wanted. Unfortunately, they are choosing to engage in political brinkmanship in negotiations over the debt ceiling, potentially defaulting on the nation's debt. 

In a straightforward sense, the debt ceiling is created by enacting legislation in which Congress temporarily limits the degree to which federal government expenditures can exceed tax revenue. The shortfall is covered by issuing treasury bills, notes and bonds. On an annual basis, the difference is referred to as the deficit, while the accumulation of the yearly deficit is referred to as the national debt, which is now $31.5 trillion. It fundamentally means that the government needs to take in more tax revenue to pay its bills. The first debt ceiling was created by Congress in 1917, so this is a familiar thing.

The general timing of when the debt ceiling is hit can be forecasted with relatively high accuracy, so this problem is unsurprising. Congress had months and months to address this but instead chose to act like children pretending that some inevitable outcome and day of reckoning for irresponsible behavior is now somehow a surprise. The Treasury Department began using "extraordinary measures" back in January when the usual and customary flow of tax revenue was insufficient to pay the bills. The Treasury Department has some ability to create months of budgetary wiggle room through fiscal creativeness that mostly boils down to suspending the reinvestment of revenue generated in some federal government pension or caretaker accounts.

That wiggle room is now gone. The so-called X-date, when even the extraordinary measures fail to cover the bills coming due, is now estimated to be June 1. This date has been moved forward several months because tax revenue is running about 10% below that of the previous fiscal year. The reason is mainly attributable to the slowdown in capital gains tax revenue from realized gains in the stock and housing markets. 

Should our elected representatives choose to voluntarily default on the nation's debt because of their unwillingness to compromise on political dogma in the negotiations over the debt ceiling, well, let's say bad things will happen. Extraordinarily bad things. Global financial markets will be shaken to their core. The interest rate on the 90-day Treasury bill is referred to as the risk-free rate of return because, under normal circumstances, the government will not go out of business in the next three months. A vast array of domestic and global interest rates is benchmarked to the risk-free rate of return established by the interest rate on short-term U.S. government debt. When that rate is no longer risk-free, everyone will pay higher interest rates on all borrowings, including credit cards, auto loans, mortgage rates, and multi-billion dollar capital investments like those in Georgia's budding electric vehicle industry. 

At a minimum, the federal government would need to decide which bills coming due would be paid, thereby creating a class of winners and losers regarding who gets paid and when. Fundamentally, the tradeoff is between trying to calm financial markets by paying the interest due on debt versus mitigating the severity of the default-induced recession. The optics are not good if Treasury makes winners out of bondholders, and 25% of that debt is held overseas, and makes losers out of older people relying on their Social Security payment.   

In the long run, when a government defaults on its debt, it faces much higher interest rates in the future when borrowing again in global capital markets. Greece in 2012 and 2015 is a case in point. When Greece effectively defaulted, investors demanded higher interest rates to compensate for the increased risk on Greek bonds. The 10-year rate on Greek bonds skyrocketed to 35% from about 4% and remained elevated for eight to nine years. 

Hopefully, our elected representatives in Washington, D.C., will acknowledge the real and lasting damage a default of the world's largest debtor nation would cause now and in the future. We'll be back at this in a few years when the next debt ceiling cap is again under siege.

Michael Toma, Ph.D., is the Fuller E. Callaway professor of economics in the Parker College of Business at Georgia Southern University in Savannah. He specializes in macroeconomics and regional economics and holds a Ph.D. in Economics from George Mason University in Fairfax, Virginia. He joined Armstrong State University in Savannah in 1997 and continues with Georgia Southern University today. He can be reached at [email protected].