7 Consequences of the Potential Debt Default
Grow Your Business, Not Your Inbox
Faced with some Republicans shrugging their shoulders at the thought of the U.S. defaulting on its debt obligations for the first time ever, notable economists are warning that the consequences would be the economic equivalent of a swarm of frogs and a plague of locusts.
The worst of the doomsday scenarios painted by economists involve an outright depression, as the effects of missing a debt interest payment cascade through the economy, financial markets and ultimately to Main Street.
While many analysts agree that a default still remains unlikely, warnings are beginning to intensify that Washington is skating too close to a perilous line.
"The devastation to the United States would be so severe that it would take decades to recover from the Depression caused by a default and the attendant dumping of trillions of dollars of U.S. Treasury securities on the global financial markets," banking analyst Dick Bove, at Rafferty Capital Markets, said in a report for clients.
Here are seven of the most immediate and severe side-effects if lawmakers fail to raise the debt ceiling in time to avoid default:
1. Depression and unemployment
Financial shockwaves, beginning at the Treasury and Federal Reserve, would make their way through banks and eventually blow a hole through the Main Street economy. Just as in the 2008 financial crisis, businesses would quit hiring amid the uncertainty. The unemployment rate would rise from its current 7.3 percent.
As an illustration, the jobless rate was 5.0 percent in December 2007, about where it had been for the previous 30 months, according to the Labor Department. By the time the Great Recession ended, it was at 9.5 percent, and peaked at 10.0 percent in October 2009.
A slew of other events would slam the economy: A drop in stock market prices, hurting many Americans' 401(k) investments; the seizing up of bank lending; and the U.S. losing standing in the international marketplace. With U.S. economic growth still below 3 percent, it wouldn't take that much to send the nation into a financial tailspin.
2. Dollar down, prices and rates up
Among the biggest impacts could be mass selling of the U.S. dollar, an event that would threaten the greenback's standing as the world's reserve currency.
That would pound consumers' buying power by boosting prices for everything from groceries to clothing to the gas we pump into our cars.
"In the event of an actual default, Treasury yields and other borrowing costs would probably rise and remain higher," warned Julian Jessop, Capital's chief global economist.
So homeowners and prospective homeowners would have to say goodbye to the low mortgage rates they have enjoyed while the Federal Reserve has kept its foot on the economy's gas pedal.
"All the money you're gonna have is under your pillow, and it probably won't be worth as much as it is today," Kyle Bass of Hayman Capital Management told CNBC's Squawk on the Street. "But I don't think we're going to get to that apoplectic point in the U.S."
With economic growth still below 3 percent, it wouldn't take that much to send the nation into a financial tailspin.
3. Down go your investments
Stocks have had a rough week, with the S&P 500 and Dow industrials off about 2 percent each and the Nasdaq down nearly 4 percent. That raises worries for many Americans whose nest-eggs are held in company 401(k)s and other retirement accounts.
During the last financial crisis in 2008, major U.S. equity indexes tumbled, with the S&P 500 Index losing 37 percent for the year, which translated into big losses for many 401(k) retirement plan assets, according to the Employee Benefit Research Institute.
Just how individual 401(k) participants were affected by the downturn largely depended on the mix of assets in their funds. For example, investors with a high percentage of their 401(k) in stocks (versus bonds or cash) took a bigger hit than those with more balanced funds.
While many analysts have been trumpeting the market's refusal to panic over the prospect of a default, that relatively sanguine reaction likely would change.
Estimates among Wall Street analysts are the market would drop between 10 percent and 20 percent -- with the upper end at what Wall Street defines as a bear market.
4. Social Security payments halt
The current projection for the government to run out of money to pay its daily bills is Oct. 17. Economists believe, though, that the Treasury would have enough money on hand to pay its $12 billion Social Security payment due that day, as well as another one on Oct. 25.
That may not be the case come Nov. 1, though, when there's a $25 billion payment due, meaning that checks may not get issued past that date.
Nov. 15 stands as a larger date overall when the Treasury won't be able to make a $30 billion debt payment.
"We strongly suspect the current impasse over spending and the debt ceiling will have been resolved well before then," Capital Economics said in a report. "There is also a chance if the shutdown was still in effect at that point then the Treasury, perhaps with the Federal Reserve's help, would be able to avoid a default somehow. But in a worst case scenario, this is the date to watch."
5. Banking operations freeze up
One chilling data point: American banks own $1.85 trillion in various government-backed debt, Bove calculated.
The effect, then, of a default on that debt would be devastating.
"If the Treasury and related securities were in default, one does not know what they would be worth," Bove said. "Assume a Latin American valuation of 10 to 20 cents on the dollar and an estimated $1.28 trillion in U.S. banking equity would be wiped out.
The potential result?
"It is my strong belief that a true default by the United States Treasury would wipe out bank equity," he said. "All bank lending to the private sector in the United States would stop, immediately. Existing loans would not be rolled over. Immediate repayment would be demanded."
6. Money market funds break
The $2.7 trillion money market industry operates on a basic premise: Millions of American depositors won't lose money.
That agreement broke briefly, with one fund, during the 2008 financial crisis, to destructive effect on investor confidence. It could happen again in the event of a default.
A recent Federal Reserve study said the damage during the crisis eventually could have involved 28 funds that would have "broken the buck." Bove said a default would hit "virtually every money market fund in the country."
"At present, (money market funds) that do not actually earn enough money to pay back 100 cents on the dollar are subsidized by the fund management company," Bove said. "A Treasury default would make this virtually impossible and millions of Americans would lose billions of dollars."
7. Global markets walloped
Some of our biggest trading partners are equally rattled by the prospect of the U.S. defaulting on its debt. The International Monetary Fund this week warned that a default would push the U.S. economy back into recession and cause "major disruptions" for global markets.
Meanwhile, China and Japan--the largest foreign holders of U.S. Treasury debt--have stepped up calls for quick action. China and Japan held $1.28 trillion and $1.14 trillion in U.S. Treasury securities, respectively, as of July 2013, according to U.S. government data. A fall in U.S. government bond prices would deplete the value of their reserves.
Saber-rattling by China and other foreign investors aside, there is little actual chance the governments who own America's debt would actually sell it. To do so would cause a panic that would make their investments worthless--the diplomatic equivalent of cutting off their nose to spite their face. That said, investors might see a dip in the value of their international funds.