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Raising the Debt Ceiling

Here’s exactly what will happen if we default on Thursday

Oct 14, 2013
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Raising the Debt Ceiling

Here’s exactly what will happen if we default on Thursday

Oct 14, 2013
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COPY

Here’s the worst-case scenario: The U.S. Treasury misses a payment.

As markets open from Tokyo to New York, “you’re gonna see stock markets sell off,” says Eric Stein, co-director of global income with investment management firm Eaton Vance.   

As markets fall, they wipe out a lot of wealth along the way — think about your 401(k).

In fact, Stein says markets would react before any payment is missed. And that market movement alone would be dramatic enough to force politicians to act.

When you or I miss a payment on our credit card, our interest rates go up – the same thing would probably happen here.  

But government interest rates are tied to a lot of other interest rates.

“When it gets more expensive for the U.S. government to finance its debt, it becomes more expensive for everyone to finance their debt,” says Sam Chandan, chief economist at Chandan Economics.

Think mortgages, car loans and student debt. That’s the effect a default would have on people. Next, the banks will start to feel the pain, as the default starts to gum up “the plumbing of the financial system,” says Eaton Vance’s Stein.

Banks use short-term government debt as collateral when they borrow from each other every single day. If the banks don’t have collateral, or that collateral becomes less valuable, they have trouble lending to each other.  If they can’t lend to each other, they sure can’t lend to you.

(If you want to learn more about this subject you can go here.)

“There’s a seizing-up of the credit markets, less funding goes out ot the real economy, whether that be less funding for large corporations, mortgage backs, small companies,” says Stein.

This has happened before, in 2008, warns Michael Farr, president of Farr Miller & Washington and author of Restoring Our American Dream.  Back then, it was mortgage-backed securities that were tainted, as opposed to U.S. government debt.  

“One bank started to worry about the obligations that another bank was using as collateral for overnight loans.  The one bank said ‘I don’t think your collateral is worth what you think it’s worth’. They stopped lending overnight,” says Farr. That ‘other bank’ was Lehman Brothers.  Overnight liquidity dried up, and “all of a sudden, Lehman brothers — which was financially viable two days earlier — went under. Things can move very quickly.”

Even flirting with these consequences has consumer confidence at a nine-month low. When consumers are uncertain, they keep their money in their pockets. That itself can slow down economic activity.

But few expect that to happen.

“They might go up to the last second of the last hour,” says Eric Stein, “but I think an actual default is very, very unlikely.”

In the words of Michael Farr, “that’s a really moronic, stupid thing to do.”

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