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Regulatory: Thinking About the Unthinkable—Partial Default

A government default would result in significant global consequences.

On May 16, the federal government reached its statutory debt ceiling of $14.29 trillion. Treasury cannot borrow more until Congress provides new authority. Congressional Republicans are demanding substantial reductions in spending, without new taxes, in return for raising the debt ceiling. The two political parties have joined an enormous game of chicken—the hardest part will be knowing when to pull out. A mistake could have devastating effects on the country’s single greatest asset: the willingness of others to do business in our money.

The plan for managing a debt-ceiling crisis was written by President Reagan and employed by President Clinton. The government can avoid default for several weeks through a series of one-time-only cash management tricks to defer payments and accelerate receipts. For example, Treasury has announced it will not make deposits into federal employee pension funds. It also can slow the payments of other obligations, such as tax refunds and contractor invoices, while offering debtors discounts for faster repayments. 

These cash management techniques, plus the estimated tax payments Treasury will receive on June 15, should delay default until approximately August 2. After that, default is inevitable, given the sheer size of the deficit to be financed. This year, federal revenues will total approximately 60 percent of federal outlays, leaving a budgetary hole of 40 percent to be filled. The gap is too large to be filled by expedients such as selling the gold reserve or surplus federal property. The nature of the expenditures makes spending hard to cut. New York Times columnist Paul Krugman has described the federal government as an insurance company with an army. It has assumed risks that other Americans are unwilling or unable to bear, such as the costs of health care, pensions for senior citizens and the de facto nationalization of Fannie Mae and Freddie Mac. The payments to make good on these guarantees, plus the costs of defense and servicing the national debt, constitute the vast proportion of federal spending. Even if politically feasible, abolishing many other federal programs would not make a substantial contribution toward closing the budgetary gap.

In a default scenario, Treasury would have to determine how to prioritize which debts to honor and jury-rig a payment system. Payment of principal and interest on the national debt would be the top priority and feasible to implement, given the relatively small number of accounts through which debt is presented for payment. Beyond that, the consequences of default and their magnitude are unknowable. To degrees that cannot now be estimated, interest rates that lenders would demand to hold our debt would rise, and the value of the dollar would drop, once our reputation as the safe haven for investments was compromised. Partial default also would accelerate efforts to develop synthetic assets to substitute for the dollar as the reserve currency.

In a default scenario, the greatest immediate risks to the financial system likely would arise from marketplace disruptions, as investors are forced to reposition their assets. When Lehman Brothers failed, no one could have predicted that money market funds would fail due to their overexposure to its paper, or that their failure would trigger a mass exodus calmed only by federal guarantees. No one has lived through a failure of the world’s reserve currency, and no one knows if new guarantees offered by the federal government would be effective in halting hot money flows after its trustworthiness as the lender of last resort had been compromised.

It is important that the country never put itself in a position where we discover the answers to these questions.

John F. Cooney is a partner in the Washington, D.C., office of Venable.

Read John Cooney’s previous column.

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John Cooney

John F. Cooney is a partner in the Washington, D.C., office of Venable.

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