What if Congress doesn’t increase the debt limit? The risks of default
We all make financial decisions every day. Some are riskier than others. Taking your earnings and investing them in a Fortune 500 company is a much safer bet than providing your bank account number to a stranger who promises to wire you millions of dollars.
Prudent individuals recognize potential risks, determine how much risk is too much, and make decisions accordingly. As the president and Congress confront the nation’s debt limit—an issue that impacts all Americans, as well as the global economy—they will have to weigh the risks, both known and unknown, of failing to take action.
What the debt limit is
The United States government has a lot of debt—$16.7 trillion to be exact. This debt results from the fact that, in most years, the federal government spends more money on programs and services (such as the military, Social Security benefits, and food stamps) than it receives in revenues (such as from taxes on income). The U.S. Treasury Department must borrow money to cover the difference; otherwise the government would not be able to pay all of its bills.
The debt limit, a constraint that Congress imposed in the early 1900s, prohibits Treasury from borrowing more than a certain amount. Policymakers have regularly increased this amount as the country has grown and accumulated additional debt.
As of this past May, however, the debt limit was reached and an increase has yet to be approved. When the debt limit is reached and net additional borrowing is prohibited, certain actions can be taken by Treasury to continue paying the nation’s bills, but these are only temporary. At some point, if the debt limit is not increased, Treasury will not have enough cash in the Federal Reserve Account (the nation’s checking account) to pay all obligations due on a given day; we call this day the X Date.
At the Bipartisan Policy Center (BPC), we have projected that, if the debt limit is not increased, the X Date will fall between October 18 and November 5 of this year. A more specific projection is difficult because cash flow, especially revenue, is volatile and subject to some uncertainty.
Recent debt limit debates
Increases in the debt limit have often been opposed by the party not in control of the presidency, requiring the increase to be paired with other policy compromises in order to pass. This time, President Obama, who notably voted against a debt limit increase when he was a United States senator, has called on his opponents in Congress to send him a debt limit increase with no additional concessions—a refusal to negotiate.
In recent years, the issue has become more contentious. In August 2011, after a series of fruitless negotiations between President Obama and Speaker Boehner, legislation was enacted to increase the debt limit in exchange for $2 trillion in cuts that mostly affect domestic and defense discretionary spending.
Congress had the opportunity to use an accelerated process to replace some of these cuts with more comprehensive reforms to entitlements and the tax code, but failed to do so. As such, automatic, across-the-board cuts, known as the sequester, have taken effect, resulting in everything from furloughs (essentially forced, unpaid vacation) for Department of Defense civilian employees to shrinking enrollment in the Head Start pre-school program for low-income children.
This year, the Republican leadership of the House of Representatives may insist on tying a debt limit increase to certain provisions that would be unacceptable to the Democratic Senate and the president, such as defunding or delays in Obamacare.
Additionally, Congress still cannot agree on broader deficit reduction strategies, such as reforms to the tax code, Social Security, or Medicare, which might be more logical compromises to help pass a debt limit increase. This stalemate has caused many to wonder about the inherent risks being taken if Congress and the president fail to increase the debt limit in a timely manner and the U.S. government is incapable of making payments owed, which would be unprecedented in the modern era.
No one can know what would happen if the nation suddenly found itself unable to pay all of a day’s bills. Furthermore, we can’t even predict exactly when that day will come, although we are reasonably certain that it will occur in the latter half of October or very early November.
What happens on the X Date?
But when that X Date arrives, one fact is certain: the Treasury Department will not have enough cash to pay everyone who is supposed to be paid. As such, some people and organizations would risk not getting paid.
Some have suggested that Treasury prioritize certain payments over others. In other words, the government would pay some bills in full and on time, but not others. Presumably, interest would be paid on the nation’s outstanding debt first, but how would officials decide who gets paid and who does not? It may be a moot question; Treasury’s computer system may not be capable of selecting some bills to pay while ignoring others (although interest payments, which are handled by a separate computer system, may be an exception).
Another scenario, which may be more practical, would involve delaying each day’s payments until enough revenue was collected to make that day’s worth of payments at once. At first, payments would be delayed by a day or two.
But, these delays would quickly increase to weeks and then months. The bottom line is that, after the X Date, the federal government will only have enough revenue to pay about 70 percent of its bills. An immediate 30 percent cut in spending means a lot of people and businesses that are expecting federal payments will not be receiving them, and this would have a cascading effect on the economy. Late payments or skipped payments to a defense contractor or a physician serving Medicare patients might mean they can’t make payroll or pay their rent on time.
As the U.S. approaches and when it crosses the X Date, a new element of risk would derive from the market for Treasury debt. The money borrowed by federal government (i.e., its debt) is raised through regular auctions of securities, such as Treasury Bills. Investors bid at these auctions, which means that they offer to lend money to Treasury at a particular interest rate. The proceeds from these auctions are then used to pay back investors whose securities are maturing. The two pieces of this equation comprise a routine “roll over” of government debt.
The reason that interest rates on Treasury debt tend to be low (compared to stocks, corporate debt, or the debt of other countries) is that U.S. debt has historically been considered the safest asset on the planet. If investors see the U.S. government failing to pay bills on time, however, they may no longer view our debt as safe. In that case, fewer investors may want to lend money to the U.S. government, or they might demand higher interest rates to do so, which could result in much higher interest costs for taxpayers.
Because Treasury routinely rolls over large amounts of debt—over $100 billion in a single day is not uncommon—if not enough investors showed up to buy new debt, the U.S. could be unable to pay back the holders of maturing debt, leading to a default. Harder to quantify and predict would be the impact of default on broader market behavior. If the safety of Treasury debt is questioned, what happens to the value of other assets? Would credit markets continue to function, or would we experience a freeze similar to, or worse than, what occurred during the recent financial market crisis?
The bottom line is that stakes are high and risks are enormous. What is certain, however, is that every day the debt limit remains unresolved, those risks grow, with global markets and domestic investors becoming less and less confident about what lies ahead.
Shai Akabas and Brian Collins are policy analysts for the Bipartisan Policy Center’s Economic Policy Project. For more information on the debt limit, view BPC’s analysis here. If you have a question or comment, tweet @BPC_Bipartisan and @ConDailyBlog. You can also follow the authors at https://twitter.com/ShaiAkabas and https://twitter.com/BrianCPolicy
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