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What Is a Government Default on its Debt?

In recent weeks, some policymakers and media mavens have opined that if the United States pays in full and on time the principle and interest on its sovereign debt, then that means no “real” default has occurred, just a “technical” default. First, elementary but important facts:

  1. The United States issues sovereign debt, which pays interest to holders of that debt and is redeemed at face at maturity;
  2. Sovereign debt is NOT the only indebtedness of the United States – we have millions of payment obligations that come due every day;
  3. Either of these categories of debt can be paid only if the United States Treasury has the money to do so; and
  4. A failure to pay any of these debts is to default on those debts

Last year, Jason Zweig of The Wall Street Journal and economist Donald Marron noted that on at least two occasions after World War II, the United States did, indeed, default. The results were similar: a spike in interest costs to the United States taxpayer. One of the defaults led to an unintended delay in defense spending and likely prompted a recession.

Focusing merely on sovereign debt presents much too narrow a perspective on what might happen if the United States fails to increase its debt ceiling within the next 6 weeks or so.

In addition to the sovereign debt, the United States owes literally millions of other entities: contractors, pension recipients, Medicare health providers, veterans, Social Security beneficiaries, and more, as outlined in the letter from the Treasury Secretary to Congress on Monday.

As an example, let’s imagine Joe’s Tool and Die Shop in Ohio, a business of 200 employees that, among other things, sub-contracts to a larger, government defense contractor. In the normal course of business, Joe’s shop completes its work on a project and sends a bill to its defense contractor. The defense contractor confirms the legitimacy of the bill and passes it on to the Department of Defense (DoD). The DoD confirms the bill and its amount and the DoD computers send the bill to Treasury computers for payment.

This happens literally millions of times every single day for all the agencies of the federal government. Whether it’s a bill to repair a courthouse or to pay physicians through Medicare, most of the action is computerized.

What happens if Treasury doesn’t have the money to pay Joe’s bill?

Analysts have spent a great deal of time noodling on this question. Can Treasury prioritize payments of legitimate debt? If legal to do so, can prioritization be carried out as a practical matter? Can payment of the sovereign debt come before other kinds of debt, since a separate computer system is devoted to sovereign debt than to other debts?

Our best guess, an informed guess, but still a guess, is that Treasury will decide it cannot as a practical matter prioritize among non-sovereign debt. The Secretary cannot decide whether to pay the courthouse bill that came in at 9:00 a.m. instead of paying the Medicare debt that arrived at Treasury ten seconds later.

Instead, as discussed last year, Treasury may well decide to pay none of the bills that came in on that day. Instead, Treasury would wait until sufficient government receipts come in to meet the entire day’s obligations.

If Monday presents Treasury with $15 billion in obligations, but Treasury only has $10 billion on hand, the department could wait until sometime Tuesday or later in the week, when additional receipts of $5 billion come in. Then, Treasury would have $15 billion to pay all of those bills deferred from Monday.

Of course, as the days went by, Treasury would find itself deferring payments for a longer and longer time, since the government runs deficits. Eventually, this kind of “reverse Ponzi scheme” would crash and burn. Salaries, pensions, contractor bills—all would face longer and longer delays until payment.

And, one day, it might happen that even the sovereign debt obligations could face default. Why? Because at some point Treasury will accumulate such a backlog of deferred bills that it doesn’t have enough in its coffers to even pay sovereign debt on time and in full.

As Federal Reserve Chairman Ben Bernanke said recently, the result would be “calamitous.” Not only would the national economy suffer as individuals waited to be paid, but global financial markets would spasm. Treasury Secretary Douglas Dillon discussed a similar situation in a speech way back in 1963, when the United States faced a confrontation between the Executive Branch and the Legislative Branch on a debt ceiling increase.

All of this talk should, of course, be merely theoretical “scenario” talk in a university finance class somewhere. But, it isn’t. Within the next 6 weeks or so, Congress must raise the debt ceiling or the default chain we have outlined above will happen.

If Treasury runs out of money, the result would be much more than a “government shutdown” brought by failure to appropriate monies to the agencies. We would experience a true government shutdown.

Congress and the President must not take dogmatic positions on the debt ceiling. If negotiations are necessary to increase the debt ceiling, then both the president and Congress must negotiate a solution. Failure to do so will give America a serious black eye internationally and a serious recession domestically.

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