What a Debt Ceiling Default Would Do to Your Debt

What will happen this week if the U.S. government has maxed out its credit cards, as is expected to occur on Thursday?

Here’s the truth: No one really knows. It’s quite likely Oct. 17 will come and go and no one will notice. Markets may yawn that day, and Americans won’t even be slapped in the face by locked national parks or disappearing pandacams, as they were when the government shutdown took effect earlier this month.

But if the U.S. reaches the debt ceiling, it could be the day that America’s status as world power ends, not with a bang but a whimper. The impact of the federal government not paying some bills, which will almost certainly occur should partisan bickering continue much past Oct. 17, will be much more subtle, and much more significant, than the closing of national parks.

The debt ceiling, enshrined in federal law back in 1917, functions like a credit limit on your credit card. When reached, the government will no longer be able to borrow money to pay its bills, as it must do every day.

What Hitting the Debt Ceiling Looks Like

When spending hits the ceiling, some bills will still be paid. Uncle Sam still has some change in his pocket, and like a waitress in a bar, still goes home every day with some cash through tax receipts. That money will be used to pay the military, pay Social Security, pay China for interest on the U.S. bonds it holds, and pay for the staff at the gym in the Capital building. But of course, there’s not enough to go around. So some bills will go unpaid.

When that occurs, you are unlikely to see bread lines forming on the street, and banks collapsing like dominoes. In fact, you might not even see a big sell-off on Wall Street. The power company doesn’t shut off your power the first day you fail to pay the electric bill. China might not even react if the U.S. is late by a couple of hours, or even a few days, with interest payments. The U.S. probably has a grace period with its creditors. That means debt ceiling day will probably be less eventful than, say, Lehman Brothers day.

This will almost certainly bolster the voices of those who say hitting the debt ceiling is no big deal. It will make those pointing toward an Oct. 17 catastrophe look like they were crying wolf. The debate could drag on for days, or weeks.

The pain of hitting the debt ceiling will trickle out in the following few weeks. The U.S. Treasury Department says it has big bills to pay by the end of the month: $12 billion for Social Security on Oct. 23; $6 billion for debt interest on Oct. 31; and $67 billion for Social Security, Medicare and soldier pay on Nov. 1. Some of those bills will be paid, and some won’t, mainly based on how good Uncle Sam’s tips are that week. Which checks will bounce? Some will argue, persuasively, that making interest payments matters more to the long-term health of the nation than paying salaries or Social Security. But who wants to be the politician explaining why Chinese bondholders get their money while soldiers don’t?

No matter: Treasury has said it has no legal authority to prioritize bill paying anyway, so the outcome will be random. Some of the impact can be muted by the Treasury using old tricks such as “accidentally” sending the electric bill check to the water company, and vice versa, but the Treasury has already been employing such tactics since May. By the end of this month, somebody’s not getting paid without a debt ceiling increase.

Failing to pay federal workers, who will then fail to pay their personal bills, will be an immediate drag on the economy. But some of them are already being stiffed anyway. Even if you don’t get paid by Uncle Sam, but you have debt, you’ll feel a short-term impact. You almost certainly will start paying more for that debt, and soon. There’s a chain reaction in borrowing markets that links U.S. bond prices to everything from mortgages to credit card interest rates. The moment the U.S. doesn’t pay a debt it owes, lenders will charge the U.S. more to borrow, as a sort of penalty interest rate kicks in. The longer the non-payment, the more interest that lenders demand will rise. Interest rates on consumer debtwill rise right along with them. If you want one piece of advice to prepare for a debt ceiling disaster, it’s this: deal with your personal debt. Before your credit card issuers raises your rates, pay down those credit card balances.

But if the U.S. debt ceiling crisis drags on for days, such advice will sound akin to telling an expectant father to boil water while his wife enters contractions during child-birth. The long-term implications of the government missing payments could be far, far more serious than any impact you will see in credit card rates or the Dow in late October.

Paying your bills is important. Many U.S. consumers know that even one missed payment on a credit card could potentially cost thousands of dollars in extra interest when obtaining a mortgage down the road. Lenders have long memories on such things. And so it is with those who lend to the federal government.

A Tradition of Paying Up

America was born, and set on course to become a world power, by its devotion to paying its bills. Of all the magical things that happened during America’s Revolutionary Period, this might be the most magical: Alexander Hamilton, as first Treasury Secretary, tied the nation together by convincing the federal government to assume all state debt incurred through the fighting of the Revolutionary War, and agreed to pay borrowers back at fair market interest rates. This accomplished two things. First, it bound the states together, giving them a reason to want the federal government to succeed. Second, it signaled to the rest of the world that America was a great place to invest. Hamilton had seen how the British managed to outlast European powers that seemed to have more military might because the U.K. had more borrowing power. He wanted this for the fledgling country.

It worked. Since then, America has never defaulted on a debt. Ultimately, this reliability helped turn the U.S. dollar into a de facto international currency. Still today, despite all the political infighting, U.S. Treasuries are effectively as good as cash all around the world, giving America tremendous economic power. Should that global confidence be shaken, not only will borrowing costs rise — they could rise for a long time. More than 200 years of goodwill could be squandered; so will the flexibility and influence that comes with printing the world’s favorite currency.

In truth, the world will probably look past a short payment crisis. But not a protracted one. What is the imaginary grace period international bondholders might give us? No one knows; I’m not sure we want to find out.

Hamilton faced many skeptics, including George Washington, when selling his plan to create a national bank to nationalize the debt. Southern states owed less than former New England colonies. To broker a deal, he horse-traded something seemingly symbolic — the location of the U.S. Capital. In exchange for taking on New England’s debt, southern states won the right to build the capital city in present-day Washington D.C. How ironic that Washington might now ruin 200 years of goodwill and good habits with a few weeks of political opportunism.