I know a Washington state single mother who lives in a trailer. Her Facebook posts are generally about her son or her church—never about the news or politics. Except, that is, for seven days ago, when her thread took on the U.S. government shutdown: It would not affect social security cheques, she noted with relief. All was good.
But all will not be good if the U.S. bursts through its debt ceiling of US$16.7 trillion. The current government shutdown is the result of a temporary funding gap in Washington’s discretionary spending, which includes everything from defence to national parks. It has no impact on that other, much bigger slice of the federal budget: mandatory spending. This includes social security and health insurance for seniors and the poor. In a debt-default scenario, though, payments owed by any part of the government could freeze.
The classic narrative about breaking the debt ceiling is that catastrophe will ensue because it will cause financial market panic. Treasury yields would sky-rocket, rating agencies would further downgrade America’s credit worthiness. It would be chaos. The U.S.—perhaps the global economy, even—might fall back into recession.
There’s another, less well-known story about the debt-ceiling, though. Catastrophe, it argues, might come not from the markets, which have so far handled the crisis with remarkable calm, but from an unprecedented, abrupt fiscal shock. Investors, after all, are the most likely to get paid. Hitting the debt ceiling means the Treasury will have to pay its bills exclusively with incoming revenues, which are currently running $600 billion, or 4% of GDP, below government outlays, according to CIBC’s Avery Shenfeld. (The sequester cuts, by comparison, amount to “only” $92 billion a year.) Treasury computers are wired to keep issuing cheques on a first-come-first-serve basis until the money runs out. There is no way to distinguish between recipients—expect for Treasury bill holders, whose payments are processed via different software.
Should Washington decide to prioritize bondholders it technically could do so (and, if push comes to shove, it probably will), argues Gavyn Davies of the Financial Times. Still, according to Shenfeld, a 4% contraction of GDP annualized to what’s owed to every other payee would be “enough to cause a recession, if it persisted.”
Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy.