Tags: Debt Ceiling

What Happens if We Hit the Debt Ceiling?

By , Money Morning •

With possibly less than a month before the United States hits its $16.4 trillion debt ceiling - aka falls off the "debt cliff" - the country is wondering what happens if Washington fails to raise the limit.

Almost everyone agrees that even though the GOP has hinted it will refuse to raise the debt limit to get its way with spending cuts, Congress will agree to another increase. The debt ceiling has been raised 79 times since 1960.

What could happen if it's not raised is a bit of a guessing game, since it's never happened before. But the consensus is we don't want to find out.

As Princeton professor and former vice-chairman of the Federal Reserve Alan Blinder wrote in The Wall Street Journal Monday morning, "Since the federal government has never crashed into the debt ceiling before, nobody knows exactly what will happen if it does. But whatever does happen, it won't be pretty."

Here's a look at what could go down.

If We Hit the Debt Ceiling, Who Gets Paid?

Hitting the U.S. debt ceiling - or, falling off the debt cliff - means the government may not borrow any more money, so some payments would have to stop immediately.

As Blinder outlined, "At current rates of spending and taxation, federal receipts cover less than 74% of federal outlays. So if the government hits the debt ceiling at full speed, total outlays-which includes everything from Social Security benefits to soldiers' pay to interest on the national debt-will have to be trimmed by more than 26% immediately. That amounts to more than 6% of GDP, far more than the fiscal cliff we just avoided."

The Obama administration would be faced with a stark choice: Do we pay the interest on the national debt and avoid technical default?

If that is our choice, then we must also choose who will not get paid.

Will it be soldiers in Afghanistan? Retirees dependent upon their Social Security checks? Taxpayers waiting for tax refunds? Small businesses that have performed work for the U.S. government?

That then raises the question of who will be paid. After paying the interest due to the holders of U.S. Treasury notes and bonds, it seems most likely that the salaries of federal government workers, including the military, would get paid next—perhaps with a bit of a haircut. Social security checks could be paid out of accumulated reserves for a short time but government contractors might find that their payment terms have been suddenly extended.

The World After Falling Off the Debt Cliff

If we do hit the debt ceiling, the nation's credit will take a shellacking.

Blinder says that the U.S. economy would immediately enter a recession, making the debt problem worse. It would also see its credit rating cut again, which would result in "higher borrowing costs for years, maybe decades, to come," said Blinder.

Global debt markets would quickly descend into chaos.

Not only would U.S. government spending have to be cut by 26% immediately, but every money market fund, pension, mutual fund or any other investment vehicle you would care to name will suddenly be faced with massive losses.

"Markets would be caught flat-footed if the threat of default suddenly materialized...," Blinder wrote. "If threatening default comes to be seen as a standard weapon of political combat in the world's greatest democracy, U.S. government debt will lose its exalted status as the world's safest asset. Treasury borrowing rates will soar while the dollar and the stock market sink."

No one would know what U.S. Treasury obligations are worth. Banks would be unwilling to lend to each other because they could not tell if their counterparty was actually solvent or not. Liquidity would immediately dry up, quickly taking a severe recession and turning it into a depression.

This would be a global phenomenon. Because everyone owns U.S. Treasuries, no one will be spared.

That sounds like a big step along the road toward the total collapse of the U.S. dollar and Weimar-style hyperinflation.

"In short, the consequences of hitting the debt ceiling are too awful to contemplate..." Blinder said. "A sane Congress wouldn't even think about it. So let's assume that Congress is sane and raises the debt limit in time."

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