Yesterday the Obama administration appeared to indicate that it could prioritize interest payments on Treasury bonds, which probably takes the worst case scenario of a default by the government of the United States off the table. Our full faith and credit will remain full of faithfulness.
At least for now. One of the things that the discussion of a possible default by the United States has revealed is that a default is possible. The president took default off the table only elliptically yesterday, by leaving non-payment of debt off the list of things that wouldn't get paid if we go off the debt ceiling. We still have no direct statement of policy from the White House that it will definitely make all debt payments regardless of ceiling constraints.
What's more, the very fact that this appears to be a matter of policy choice may make some investors nervous. Many people had assumed that the United States government is under some kind of legal or constitutional obligation to make debt payments. Or, at least, to pay debt before paying any other obligation. We now know that the question of debt payment is—like so many other questions about what the Constitution requires—murky at best. The importance of the 14th Amendment's line about not questioning the validity of the debt is very much in the eye of the beholder (and not necessarily the eye of the bond holder).
Some even raise the possibility of an accidental default. Like a household that has set up automatic payments of bills through credit cards, the payment systems of the United States are set up to pay all bills as they come due. Turning off some payments while leaving the others on is a technical challenge. Some doubt it can be done with 100 percent certainty that there will be no errors. So there is at least a chance that some of the bills we plan to pay will go unpaid—and if one of those is an interest payment on a bond, we'll have accidentally defaulted.
In today's Wall Street Journal, Alan Blinder points out that running into the debt ceiling would provoke a severe fiscal contraction.
"At current rates of spending and taxation, federal receipts cover less than 74% of federal outlays. So if the government hits the debt ceiling at full speed, total outlays—which includes everything from Social Security benefits to soldiers' pay to interest on the national debt—will have to be trimmed by more than 26% immediately. That amounts to more than 6% of GDP, far more than the fiscal cliff we just avoided," Blinder writes.
The fiscal cliff, by contrast, would have erased 4.5 percent of GDP.
Any sustained captivity below the debt ceiling, in other words, means that the economy will enter a severe recession. This recession will be made far worse because the so-called automatic stabilizers that kick in when the economy slumps—think unemployment insurance—will not be able to function because of the budget constraint. So unemployment will grow while unemployment insurance contracts. This will not only pose a hardship on the people out of work, it will mean that the spending power of the American consumer will shrink rapidly.
Where the fiscal cliff might have led to a recession, this is downward spiral toward depression. The shrinking economy will shrink the government's tax revenues. And since the budget deficit cannot increase, the spiral will go unchecked. Falling taxes will trigger falling spending. "Downward spiral" may be too mild. Economic black hole better fits the bill.
"In short, the consequences of hitting the debt ceiling are too awful to contemplate—worse even than going over the fiscal cliff. A sane Congress wouldn't even think about it," Blinder writes. He's absolutely correct.
Blinder goes on to propose a plan to avoid a crises based on the assumption that Congress is sane. Let's hope that assumption is correct.