What to Expect if the U.S. Defaults

By Michael Madowitz - October 10, 2013

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‘Good’ news

While a default should result in substantial short- and medium-term declines in U.S. asset values and long-term increases in interest cost of the national debt, it is unlikely the United States would experience permanent capital flight on the scale that other nations have suffered. Many close substitutes for Treasuries are other U.S.-based assets, such as high-grade corporate debt and consumer debt.

Bonds from other countries will become more favorable to investors, but uncertainty around growth prospects in Japan, the United Kingdom, and the greater euro area suggests that investors will not flock to any particular asset. In many ways, the euro is giving the United States a buffer right now. If investors could still buy deutschemark-denominated German bonds, it is likely that even the political brinksmanship in the United States would have driven investors out of U.S. Treasuries and into German government debt. In some ways, the United States is experiencing a dividend from instability in the euro zone.

Other potential risks to the economy

If the American economy were a typical one, a default would go something like this: Investors would get spooked, pull capital out of U.S. stocks and bonds, take losses, and move their money to safer assets in other countries. Back in the United States, interest rates would rise and asset prices and the U.S. dollar would fall. Imports would become more expensive and inflation would rise. Gross domestic product, or GDP, and employment would fall. A default would be catastrophic, but in an utterly predictable way. Over time, the fall in the value of the dollar would make U.S. manufacturing and exports more competitive, leading the economy out of a deep recession and bringing the country back to reasonable conditions after a mere lost decade or two.

The U.S. economy, however, is anything but typical. In the scenario described above, bondholders are typical investors who hold bonds they perceive to be of relatively high risk and return, so they are judicious in the transactions they structure based on these bonds. A default causes investors to take a hit and sell at a loss, and the defaulting country is left paying higher interest rates with less foreign investment. The response is often deemed a “flight to quality,” and investors end up buying up traditionally safe assets—typically, Treasuries.

Since the inflation-adjusted return to holding Treasuries is close to zero, U.S. debt functions less like an investment than a source of liquidity. By far, the largest concern with the House’s brinksmanship is that the U.S. economy, specifically Treasury debt, is the lynchpin of the domestic and international financial system exactly because the U.S. government has a 200-year history of never behaving this irresponsibly.

This system’s effect on every American should not be understated. Large corporations often make payroll and other transactions by using facilities that require nondefaulted Treasury-issued debt as their foundation. Many Americans have assets in money-market funds, either directly or through pensions, many of which rely on the safety and liquidity of Treasuries. Every second the United States is in default introduces unwelcome uncertainty into a very liquid financial system that relies on a high degree of trust and certainty.

Today’s fast-paced, highly electronic markets rely—to a surprising degree—on simple trust. Once any uncertainty is introduced into the system, the millions of transactions that happen seamlessly every day suddenly require considerably more due diligence than the system is built to handle, and make them less liquid.

Treasuries are directly used in many of these transactions precisely because of their liquidity and trivial risk. For example, they play a large role in the repurchase agreement, or repo, market, which banks use to meet short-term funding requirements. In repo transactions, safe assets are sold on a short-term basis with an agreement to repurchase the assets back at an agreed-upon date—often the next day—and price. This is a very large market. For example, outstanding repo borrowing by primary dealers using Treasury collateral is currently more than $1 trillion. Uncertainty about the future value of these assets may disrupt some of these transactions.

In the 2008 financial crisis, the repo market for some assets—such as mortgage-backed securities not backed by Fannie Mae or Freddie Mac—shut down and caused significant stress for several important financial institutions. Repo of Treasury securities was largely unaffected. It is possible, however, that the Treasury repo market will not be so impervious to a federal default. Lenders may no longer perceive Treasuries as riskless collateral. Moreover, transactions may be affected because many repo agreements do not permit the use of defaulted securities as collateral. Although the consequences are hard to predict, there is a risk of negative shocks to firms or Treasury market liquidity.

Threats to output and employment

If the U.S. government defaults on its payment obligations, our economy will automatically be pushed into a new round of fiscal contraction. The size of the required expenditure reduction could be very large, even relative to the size of the economy. The Congressional Budget Office estimates that the United States is currently running an annual budget deficit of about 4 percent of GDP, which is around $600 billion annually.

Cutting expenditures at this rate would directly reduce aggregate demand. That would have a negative impact on output and employment, which would increase for the duration of the default.

Moreover, there is good reason to believe that the direct effects of forced expenditure reduction would be magnified by macroeconomic “multiplier” effects. Recent academic research on the effects of fiscal contractions in economies that are operating below potential have suggested that each 1 percent of GDP in fiscal contraction can reduce GDP by as much as 3 percent. The U.S. economy is certainly below potential, so it is reasonable to expect that a federal expenditure cut of 4 percent of GDP would reduce GDP by more than 4 percent annually.

Currently, the U.S. economy is growing by a little more than 2 percent per year. Therefore, a sustained fiscal contraction of this magnitude could push the economy into recession. It is easy to see why Federal Reserve Chairman Bernanke was so alarmed by the possibility of default in 2011.

Some commentators have suggested that the U.S. Treasury could “reprioritize” payments in the event of a protracted crisis to ensure that the government would not default on Treasury security payments. The Treasury Department has made clear that this is not possible. But even if it were possible, this would only privilege payments on Treasuries over other obligations of the government, such as Social Security benefits, payments to Medicare health insurers, military pay, military benefits, and veterans’ benefits. It would not reduce the size of the fiscal contraction or its negative effects on output and employment.

Moreover, once it is clear that payment of some U.S. financial obligations are contingent on political circumstance, it is possible that a new default premium would be added to the cost of Treasury borrowing for an indefinite period of time. Hence, reprioritization could fail to prevent this damaging financial market consequence of default.


It is extremely difficult to construct a credible scenario in which the United States hits the debt ceiling on October 17 without inflicting major damage to the U.S. and world economies. At best, a default that lasts only hours and increases the risk premium on U.S. debt by even a small amount would still cost taxpayers hundreds of billions of dollars over the next decade. More likely, any larger amount of time the United States spends in arrears may well harm the real economy and disrupt financial markets.

The United States has already been through one financial crisis, which taught us valuable lessons about the financial system. Legislators would be wise to consider those lessons now. The day-to-day U.S. economy is more reliant on a well-functioning financial system than previously thought, and there is a much clearer picture of how destabilizing financial market turmoil is to the real economy. The system is also less stable and less well understood than previously assumed—an especially important lesson for legislators who are proceeding as if they can use the U.S. economy as a bargaining chip in an unrelated, entirely political disagreement.

Political considerations aside, it is all but inconceivable that Congress would be irresponsible enough to not lift the debt ceiling. This belief is likely responsible for the lack of market movement against U.S. Treasuries so far, but the lack of movement underscores how destabilizing it could be if Congress fails to lift the debt ceiling before it affects the global financial system and American families.

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This article is reprinted with permission from the Center for American Progress

Michael Madowitz

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