What Happens If The U.S. Defaults On Its Debt? Here's Why It Won't
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Audible. There's more to imagine when you listen. Go to audible.com slash imagine and discover all the year's best waiting for you. Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 433. It's titled, What If the U.S. Defaults on Its Debt? Here's why it won't.

This week, Treasury Secretary Janet Yellen reinforced her warning that the U.S. risks running out of cash as early as June 1st unless Congress raises the debt ceiling, the amount of money that the U.S. Treasury is allowed to borrow in order to meet the U.S. government's obligations. The Congressional Budget Office this week

warn there is significant risk that the U.S. government would be unable to pay all of its obligations within the first two weeks of June unless the debt ceiling is raised.

If the debt ceiling isn't raised and the U.S. defaults on its debt, Mark Zandi, chief economist at Moody's, said it would be a lethal combination. You can see how this thing could really metastasize and take down the entire financial system, which would ultimately take out the economy.

If you look at other predictions of what could occur if the U.S. government defaults on its debt because Congress didn't raise the debt ceiling, the stock market could crash anywhere from 20% to 45%. According to some predictions, interest rates would spike. Potentially, we would see mortgage rates for home purchases in the U.S. exceed 8%.

There are securities that depend on U.S. treasuries. Repurchase agreements, for example. A repurchase agreement or repo is a type of security where typically an institution borrows money and puts up treasury bonds as collateral. And the market for repos is huge. And if that collateral suddenly isn't worth what was thought, because usually the collateral is U.S. government bonds,

then there's potential repercussions throughout the financial system, throughout what's known as a shadow banking system, which are institutions that perform bank-like functions but aren't registered as banks.

25% of the U.S. economy is federal government spending. If that spending stops, it would clearly cause unemployment rates to spike because many, many people would be laid off from their jobs and the economy would take a big economic hit. And ultimately, even if the debt ceiling is eventually raised,

defaults secured, there's the potential for higher longer-term interest rates because market participants now know that Congress is willing to allow the federal government to default on its obligations, even if it's only for a few days or weeks. There's potentially longer-term repercussions of this.

Now, that's what could happen. In this episode, we're going to see why, because the consequences are so dire, it won't happen. Either Congress will raise the debt ceiling, and perhaps they'll come to an agreement with the Biden administration to cut some spending as part of that. But if they don't come to an agreement, there are some things the executive branch can do and the

the U.S. central bank, the Federal Reserve, can do to avoid default on the debt. The U.S. Constitution grants Congress the power to borrow money. It comes from Article I, Section 9, Clause 7, which says no money shall be drawn from the Treasury but in consequence of appropriations made by law. So the U.S. Treasury, the executive branch, can only spend money that's been authorized by Congress as part of laws.

Article 1, Section 9, Clause 7 says the Congress shall have power to lay and collect taxes, duties, imports, and excises to pay the debts and provide for the common defense and general welfare of the United States. It's the Congress that has the power to incur debt and pay debt. Initially, Congress would approve every single bond issuance that the U.S. government did.

They first established a debt ceiling that allowed the executive branch to borrow money up to a certain limit in 1917 as part of funding World War I. And then that flexibility was expanded even more in the early 1930s.

By March 1962, the debt ceiling or debt limit was $300 billion. Today, it's $31.4 trillion. And U.S. Congress has raised the debt ceiling over 80 times.

Back in 2017, the debt ceiling was only $19.9 trillion. That's when we last took a deep dive into the debt ceiling. That was episode 169 of the podcast. If we look at total public debt now, which is $31 trillion, it's 120% of GDP or the size of the U.S. economy. Back in 2017, it was 103%. In

and it got as high as 134% of GDP in Q2 2020. That was because of the pandemic, and the debt tends to balloon during recessions because of stimulus programs and because tax revenues fall. And we discussed that back in episode 416 on five principles regarding the national debt. And one of those principles was it tends to increase during recessions.

Now, why is it that we keep getting into this debt ceiling crisis? There was one in 2011, 2013, I believe in 2015, 2016, 2017, 2019, 2021, and now the one today.

Well, it really starts from the Budget and Impoundment Control Act of 1974. And it was that act that established additional congressional budget committees. In addition to existing committees such as the Appropriation, Ways and Means, and Finance committees, the budget is set by these committees. And it is not a smooth process. The government has shut down 22 times because...

it has been unable to pass a budget. The federal government and Congress have only agreed on a budget prior to the start of the fiscal year four times since 1974. Most of the time, Congress is passing what are known as continuing resolutions to keep the government operating on a short-term basis.

Here's the thing, though, because it's the committees that are very much involved in setting the budget, there are members of Congress that aren't part of those congressional budget committees, and the debt ceiling is what gives them the leverage to try to put forth their spending plans and spending restrictions. And so it's sort of a free-for-all for all of Congress. These debt ceiling debates allows non-competitors

Committee members that aren't part of the budget process to have some influence on what the government spends its money on. Treasury Secretary Janet Yellen has said that the government could run out of money by June 1st. The actual date is unknown. It's called the X date. And the reason why is because the government's receiving money in...

and it's paying money, but it's not like every month the same amount of money comes in, nor the same amount of money goes out. And the Treasury doesn't necessarily control what is spent in a given month because there's independent agencies or other government agencies that are spending money. And so that timing of when the government will run out of funds is not clear. So it's just sort of an estimate, which is a risk then,

a potential default because they don't actually know exactly when the money will run out.

The U.S. Treasury has been implementing what are called extraordinary measures to pay the government's bills even though the debt ceiling has been reached. And it can suspend some investments or some payments such as to the Civil Service Retirement and Disability Fund. It suspends payments to the G-Fund, which is the bond fund for the federal employees' retirement system.

The Treasury will always make that up, but there's some accounting maneuvers that can be done in order to keep the government operating even though it has reached its authorized limit of borrowing. Because of all the uncertainty that the Government Accountability Office has pointed out that these debt limit episodes are extremely stressful on Treasury staff. If you've ever been in a situation where you don't have enough money and you owe money and you're trying to

figure out who to pay, when you'll be able to make the payment, or whether you'll run out of money, it is incredibly stressful. Now, given we're only days away from the U.S. government potentially running out of money, defaulting on its debt, shutting down the government because there is no money, which makes up 25% of the economy, the stock market's been fairly placid. Even the bond market hasn't been overly worried.

In 2011, when the U.S. government got within days of its extate, the U.S. stock market fell about 20%. It eventually recovered later that year. But if we look at what's going on, the stock market hasn't really sold off. We have seen higher yields on those Treasury bills that are due around early June to mid-June.

The difference, for example, if we look at four-week Treasury bill yields, they're at 5.6% compared to eight-week Treasury bills. Their yields are 4.9%. So there's a little bit, let's say a half percent additional compensation in Treasury bills to protect against the potential for default.

If we look at credit default swaps, which are derivative securities that will pay out if the government defaults, they've reached an all-time high. But even at the level they are, it's not extreme.

The U.S. government has never officially defaulted on its debt. It did default a little bit by accident in 1979. Congress had raised the debt limit at the very last minute, but there was so much demand to redeem treasuries that there was a word processing error in sending out checks, and some of the checks didn't get sent out on time. So it's sort of a technical default, but not an official default.

Now, some, including members of Congress, have suggested and tried to pass bills that said the U.S. Treasury should prioritize who gets paid. If the debt ceiling isn't raised, who's going to get paid first? Will it be the Treasury bondholders or government bondholders? Will it be the military? How will they decide that? And the reality is that's not easy to do. While the Treasury Secretary and the staff could decide, there's a systems constraint.

The Bipartisan Policy Center found in 2021 that just the sheer number of payments that are made and how antiquated the computer systems are, that it would be very unlikely they'd be able to even implement prioritization if it was requested or passed.

The government pays money as it comes due, and it flows through its checking account, essentially its checking account, the account that it has at the Federal Reserve, and things just get paid. And they make sure there's enough money in there by issuing bonds and collecting taxes, and that's the revenue that comes in. And then as payments come due, they get paid. There's no priority. It's whenever they come in and they get paid.

Given the potential economic consequences of the debt ceiling not being raised, the government unable to make interest payments, make principal payments to meet its obligations, except for revenue that happens to come in from taxes, the potential default, major sell-off in the stock market, dislocation in the bond markets. Last fall, we did an episode on WBAL.

when volatility spikes, things break. And we don't know what would break if there was a default on U.S. Treasury bills or bonds because so much is tied up in the plumbing, the underlying plumbing of the financial system. And again, these

supposedly risk-free bonds are the baseline, and they're used in repurchase agreements and many other security structures, assuming that it is the risk-free rate. And if it's no longer risk-free because U.S. government just defaulted, then we don't really know what the ultimate consequences would be. And it's because of that uncertainty and the unknown that it seems unlikely that the

the Biden administration or the Federal Reserve would allow the U.S. government to default on its debt. Now, there are certain things, and they are highly controversial. They would lead to lawsuits that the executive branch could do or the Federal Reserve could do. Before we continue, let me pause and share some words from this week's sponsors. Before we continue, let me pause and share some words from one of this week's sponsors, NetSuite.

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The first thing is to invoke the 14th Amendment. Section 4 of the 14th Amendment says that the validity of the U.S. government's public debt shall not be questioned. That suggests that the executive branch has the responsibility and even the authority to make sure that the government doesn't default on its debt if that debt is because of laws, appropriation bills that have been passed by Congress.

The spending has already been approved. The budget deficit that came about because the government spent more than it received in tax revenues, that was known. They budgeted for a budget deficit. They budgeted knowing that they would have to issue debt. And so if Congress has passed spending bills, can they put limits on what the president can borrow?

Lawrence H. Tribe, who's a constitutional scholar, says the president should go before Congress and say, I'm bound by my oath to preserve and protect the Constitution, to prevent the country from defaulting on its debts for the first time in our entire history. My duty faithfully to execute the laws extends to all the spending laws Congress has enacted.

laws that bind whoever sits in this office, laws that Congress enacted without worrying about the statute capping the amount we could borrow. In that situation, potentially the U.S. government, Treasury Department, just could go ahead and issue more debt, taking the U.S. government above the debt ceiling. That's one option. Again, controversial.

Another option is something we discussed in a Plus episode back in January, what's known as the trillion-dollar coin. This is an idea by Rowan Gray, who's a law professor at Willamette University. He points out that Congress has given the U.S. Mint, which is under the executive branch, the ability to coin, to make coins. Now, typically, we're thinking quarters, nickels, and pennies. But there is no denomination amount that the act provides.

that gives the U.S. Mint the authority to coin money. It doesn't say how much, and it doesn't say what kind of coin. And Gray suggests that the U.S. Mint should mint a trillion-dollar platinum coin, and that that should be deposited at the Federal Reserve, so it's in the U.S. Treasury's checking account, and then they can continue to spend money. That's more of a kind of a wacky idea. Not a whole lot of talk about that, but it is something potentially that could be done.

What I think is more likely to be done, the easiest path, if Congress and the Biden administration can't agree on a debt limit increase, is the Federal Reserve will step in.

Back in 2013, when there was another debt ceiling crisis, the Federal Reserve Open Market Committee met and discussed this. And in October 2013, they said in a release, in the event of delayed payments on Treasury securities, that their operations would continue under the usual terms. And that suggests that the Federal Reserve would just make sure that things continue to operate smoothly.

At that same time, there was a memo prepared by the Federal Reserve that's never been officially released, but there was a conference call that was chaired by Federal Reserve Chair Bernanke at the time, where they talked about the different options that were available. And one option is just let the U.S. government, the U.S. Treasury, to run a negative balance on its account at the Federal Reserve. This would be a way for the Federal Reserve essentially to provide emergency lending to the government.

We know the Federal Reserve can create money out of thin air. They lend to banks all the time, as we've seen with the banking crisis. They're lending to banks now billions of dollars in order to fund exiting deposits using government bonds as collateral, which potentially are at risk. But the Federal Reserve can create money to buy bonds. It can create the money to invest.

lend to the government to keep its checking account at a positive balance. What is a dollar? A dollar is a Federal Reserve note. That's the power of the central bank. Now, the Federal Reserve could also, because it can create as much money as it wants, it could go out and purchase the bonds that are close to defaulting and fund it that way.

Jerome Powell, who was part of that discussion, he wasn't the Federal Reserve chair at the time, said there would be huge institutional risk if the Federal Reserve sort of stepped in. He said the economics of it are right, but you'd be stepping into this difficult political world and looking like you are making the problem go away.

The Federal Reserve is the lender of last resort. It tries to make problems go away to keep the economy growing, unemployment down, and they have continued to expand what they do, and their flexibility to do that has grown since the early 1970s when the U.S. went off of a gold standard. Now, there were a number of policymakers at that meeting, such as Schumer,

future Fed chair Janet Yellen and the current New York Fed chair John Williams, and they pointed out that the Federal Reserve would need to do something even though it's repugnant. Like, they don't want to. The consequences of the default are so potentially dire and completely unknown that the Federal Reserve would do whatever it took to keep the U.S. government from defaulting on its debt.

There still needs to be a solution, though. There needs to be an agreement, and there needs to be a better budgetary process.

In episode 416, we pointed out five principles. The absolute level of the debt doesn't matter. The national debt is going to continue to increase. That was principle one. Principle two was it will never be paid off. They just refinance the debt, roll it over all the time. Principle three is what we pointed out earlier, that the national debt tends to increase the most during recessions. Principle four is it matters who owns the debt and the currency.

Because the U.S. government debt is denominated in U.S. dollars, that's what gives the Federal Reserve the power, the ability, not necessarily authority, but the ability to make sure the U.S. doesn't default on its debt because it can create the money to give to the government to keep it from defaulting.

If the U.S. national debt was denominated in euros, then the Federal Reserve couldn't do that. So having it all in U.S. dollars and most defaults on government debts, federal government debts, have been countries where a large portion of that debt was in something other than the country's home currency.

The most important principle, though, is that the interest rate on that debt needs to be lower than the rate of economic growth. So if the economy is growing at 5% nominal and the interest rate on average across the debt balance is 3%, then over time, the debt balance doesn't get larger as a percent of the economy. So it becomes more sustainable. Unless...

the government runs huge budget deficits during non-recessionary times, and then they spike even greater. And that's what we've seen in the last few years. Debt to GDP was 103% in 2017. Now it's 120%. At some point, and no one knows what that level is, investors start to get worried that potentially there could be a default because the debt's unsustainable. It keeps growing, growing, growing as a percent of the economy. It's

We have countries, Japan, where the debt GDP is over 200%. So no one really knows what that level is. For developing countries, it tends to be lower. And that's why emerging market countries tend to have lower debt balances. But with something like the US, we don't know where that level is.

Should you do anything, though, the potential for a default? Should you move money to cash to protect against some of the major sell-off in the stock market?

If it's money you need in the short term, potentially, yes, but that's money that shouldn't have been in the stock market in the first place. If you have a certain thing, say a down payment you're saving for, and that's invested in the stock market and you plan to buy a house in the next three or four years, you probably don't necessarily want that in the stock market. For your long-term investments, I don't think it's prudent to move out of those because of the debt ceiling crisis.

I was managing money professionally in 2011, the last time the U.S. got very close to default. And I was writing a series of memos to our clients. And we didn't lower our allocation to the stock market in 2011. And the market sold off. It felt awful. But then it came back. In my personal account, I actually did reduce my allocation some. And then I didn't get back in fast enough, which I learned later.

Don't be moving out of the stock market based on the debt ceiling crisis, these political events, because as we've seen, they've been resolved over 80 times now, and they will more than likely be resolved today. Now, maybe not, but there's a backstop there of the Federal Reserve, things that it can do, and the executive branch itself. It

And maybe that's why the stock markets and the bond markets aren't overly worried. Or maybe they're just complacent, knowing that over 80 times, there's at least been a short-term extension, debt ceiling raised for a little bit, and then Congress and the executive branch can continue working on creating more sustainable budgets, be more fiscally sound. I think that's an important thing. The government can't.

spend unlimited amounts. There are consequences to that, and we're seeing those consequences today with the huge amount of stimulus that was put in place as part of the pandemic combined with the Federal Reserve, purchasing bonds, quantitative easing, effectively monetizing that debt, increasing the money supply by 30%. That's a main driver of inflation. And while the government can spend as much as it wants, the

the private sector. There's capacity constraints to be able to produce goods and services. Though it isn't an issue of being able to spend as much as you want if you don't have the ability to produce the goods and services that are bought with those funds. And that capacity constraints is what led to inflation. And we've seen that once inflation takes hold, it's not easy to bring it down. It continues to come down, but it can be a long process because we get conditioned to

to high inflation and we start making decisions, assuming prices will be higher and businesses raise their prices because everybody is now comfortable knowing prices will be raised and they might raise prices more than they need to to cover their costs so their profits expand and their profit margins. Bottom line is, I don't anticipate that the U.S. government will default on its debt. There are backstops in place.

Given how dire the consequences are, more than likely the Biden administration and Congress will come to an agreement, probably short term, resolving the crisis. That's episode 433. Thanks for listening.

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