What happens if the United States fails to raise their debt ceiling?

Tuesday, August 2 (Wednesday NZ time) is usually the 'drop-dead' date referred to in the US 'debt ceiling' warnings - but it seems the crunch will come as early as this coming Saturday (Friday US time).

Unless an agreement has been reached by then, there will probably be insufficient time to pass the required legislation to avoid implications.

But 'default' may not necessarily happen then.

However, worse things could happen instead.

Nigel Gault of the international consultancy IHS has reviewed the situation from a technical perspective. Here is his report:

Failure to raise the U.S. federal debt ceiling by the deadline of August 2 would lead to a massive fiscal contraction and a financial crisis, although it would not necessarily mean a debt default.

With deficit-reduction negotiations still deadlocked, time is running short to reach an agreement to raise the debt ceiling. Discussions over a 10-year deficit-reduction package - whether "small" at around $2 trillion or "big" at around $4 trillion - have both foundered on the Republicans' insistence that no tax increases are included.

The growing fear that there will be no deal is starkly illustrated by the fact that Senate Minority Leader McConnell (Republican) has proposed a new idea whereby the president could raise the borrowing limit on his own authority (in three stages) without receiving prior approval of matching spending cuts.

This suggests that McConnell is well aware of the train wreck that would result if the debt ceiling is not raised. He has good reason to worry.

When will the debt ceiling become binding?

The current Treasury estimate is that the debt ceiling will become binding on August 2 - that will be the date on which accounting maneuvers can no longer allow the government to keep spending more than its income without breaching the $14.3-trillion debt ceiling.

When must a debt-ceiling agreement be reached?

The administration says that an agreement must be reached by July 22 in time to allow the necessary legislation to be drafted and passed. It is not clear how strict this deadline is.

What happens if the debt ceiling becomes binding?

Simply put, the federal government's spending will be limited by its cash flow. Since government revenues fall far short of its spending, this means that there will be an immediate cut of 40–45% in government spending. This cut would amount to around $1.5 trillion at an annual rate (about 10% of GDP). The Treasury would have to decide who gets paid and who does not. We do not know what it would decide - there are no precedents. The first flashpoint would be $23 billion in Social Security payments due on August 3 (which revenues received that day would not cover).

Will the U.S. default?

A debt default means that the United States fails to pay interest on its debt or to redeem maturing obligations. Since cash inflows are around $200 billion per month, while interest payments are of the order of $30 billion per month, if the Treasury decided to prioritize interest payments above other payments, it could make them. It could also refinance maturing debt, without raising the overall debt level, assuming that the markets are willing to lend.

What would ratings agencies do if the debt limit became binding?

They would put the United States on watch for a downgrade (S&P has already done so). They would probably do this even before August 2. A missed payment on interest or redemptions would definitely mean a downgrade. There might be a downgrade even without missed payments.

What would be the effect on financial markets?

For equity markets and the dollar, the impact would be unambiguously negative. Confidence in the ability of the U.S. government to fulfill its most basic responsibilities would be damaged. And the spending contraction, if sustained, would send the economy back into recession.

Interest rates would be expected to rise - but by how much is far from clear. Obviously, debt default or the risk of it would add a risk premium to Treasury yields, but at the same time there would be a massive fiscal contraction driving the economy into recession. And, once the debt ceiling is raised, U.S. Treasuries will probably still be the benchmark market yield, even if not rated AAA. So if interest rates do rise temporarily, investors will anticipate that they will fall back again once the immediate panic is over, which will limit the extent of that rise. This will also mean that short maturities would be hit harder (i.e., interest rates would rise more) than long ones.

But there would be massive dislocation in financial markets, because the recipients of government spending that fail to get priority, and do not get paid, will be unable in turn to meet their own obligations.

Bottom line?

Debt default is not necessarily an immediate consequence of failing to raise the debt limit. Catastrophic spending cuts would be an immediate consequence, driving the economy into recession and financial crisis if the debt ceiling were not raised quickly.

The idea that it would be politically possible to implement such cuts for any length of time (beyond a day or so) remains hard to imagine. 

The US is unique in that it is the only country that has a public law related to how much indebtedness the government can incur. Congress created the debt limit law in 1917. The issue gets debated often, and this sort of formal accountability is absent here in New Zealand. Other countries don't have such limits and the 'markets ' decide when too-much-is-enough, such as is happening in Europe at present. There is debate about whether this formal limit is good public policy.

Total US public debt is now US$14.294 trillion. US interests hold about 67% (a little under half is held by the Fed). Foreigners hold about 33%, of which China holds about 9%.

The US has defaulted before - famously in 1933, and not so well remembered in 1979.

"IHS is a global information company with world-class experts in ... energy, economics, geopolitical risk, sustainability and supply chain management." They are based in Colorado and employ more than 5,100 people in more than 30 countries.