Published May 10, 2023 by Tom Porter

What a US Default Would Look Like

These are tense times in the US Congress. The country will start defaulting on its debt payments as soon as June 1 if politicians cannot agree to raise the limit by then.

Matthew Botsch specializes in the economics of banking and finance

Associate Professor of Economics Matthew Botsch says economists have been warning for years that the US needs to get its finances on a more sustainable trajectory through a combination of spending cuts (including entitlement reform) and tax increases. “Immigration reform should probably also be part of the conversation,” he adds, “since the native-born population is aging and more young workers would help broaden the tax base.” The argument made by some politicians that ties these important issues to our existing debt is a fallacy, explains Botsch. “The debt ceiling crisis is about whether we will honor debts already incurred by past Congresses and uphold the full faith and credit of the United States government, not about shrinking future budget deficits.”

If the country goes into default, it will be a fairly mundane process in the beginning, says Botsch. “One day a payment like Social Security will come due, or old Treasury debt that was issued years ago will mature, and tax revenues coming in won't be sufficient, and Treasury will be statutorily unable to issue enough new debt to make up the difference.” Confusingly, he explains, the US actually crossed this threshold a while ago, but Treasury has been using so-called "extraordinary measures" to put off missing any payments. “Think of these like the way that households used to float checks, mailing someone a check before you have the money in your account and hoping you can move enough money in before the payee deposits the check.”

Botsch says it’s hard to predict exactly how a US government default would unfold as it hasn’t happened before. But, he adds, the recent turmoil in the banking sector might be a good analogy, albeit on a smaller scale. “Bank depositors are ‘lenders’ in this analogy: they have lent their money to the bank by opening checking and saving accounts and depositing their money there. When these ‘lenders’ become afraid that they won't get paid back as promised, they run to pull their money out and recoup whatever they can. In the aftermath of a bank run, the bank has trouble raising additional deposits and its cost of borrowing skyrockets because no one wants to lend it anymore. If the bank doesn't fail, it might operate at a loss for years to come because it has to pay more interest on its deposits than it is earning on its assets.”

“The debt ceiling crisis is about whether we will honor debts already incurred by past Congresses and uphold the full faith and credit of the United States government, not about shrinking future budget deficits.”

A default, says Botsch, may be something like a bank run, but on a much larger scale and with the key difference that the US government cannot fail and be shut down like a bank. “In the short run we would expect to see a fire sale in the US Treasuries market as investors try to cut their losses. The stock market will probably crash. In the medium-to-long run, US borrowing costs will be higher, making the government's long-term finances even less sustainable. Our credit rating will probably be downgraded again, like it was in 2011, the last time that Republicans in Congress pushed the country to within days of a default.”

This will hurt everyone, explains Botsch, as the cost of borrowing for the government is essentially the base interest rate for everything else in the economy. “Mortgage rates will go up; student loans will cost more. Taxes will have to be higher in the future to cover the government's higher borrowing costs.”

A default would also have international implications, he adds, as US debt currently occupies a unique position as what economists call the "global safe asset." “Our entire financial system is built upon the idea that US Treasuries are a risk-free investment. In the aftermath of a US default, even if it were only for a few days, we would likely no longer occupy that position.” It might take global financial markets a while to reach this new equilibrium, says Botsch, but the end result would be a world in which the US would hold a less central, less privileged role.