Pay grandma or China first? It's not so easy.October 9, 2013: 5:00 AM ET
The government would technically be in default the second it delays payment to any of its creditors -- not just debt holders.
By Cyrus Sanati
FORTUNE -- Breaching the debt ceiling wouldn't be the end of the world -- at least not right away. If Washington continues to squabble past the October 17th deadline the country could probably hold things together using cash for about a month or so before it had to start making the hard decisions. But if this thing goes on into December, you can just forget about Christmas this year.
Throughout the recent budget debate in Washington, the Republicans have sworn up and down that they would not use the debt ceiling as a bargaining chip to win concessions from the Obama administration. Sure, they would shut the government down, as they did last week, but they wouldn't allow the U.S. to default on its commitments by refusing to raise the debt limit. But this past weekend, House Speaker John Boehner escalated the budget fight saying on ABC's This Week, that "the votes are not in the House to pass a clean debt limit." He followed up, saying that "the president is risking default by not having a conversation with us." On Tuesday President Obama shot back saying that Senate Democrats have tried to discuss the budget with Republicans 19 times this year but were rejected.
It is unclear why the Republicans upped the stakes in their long-standing poker game with the Obama administration. It could be a face-saving move by the speaker to get the administration to agree to smaller budget concessions, so that he wouldn't have to walk away totally defeated. Whatever the reason, the mere threat of a U.S. default caused Wall Street to shiver a bit this week, with stocks taking a dive and Treasury yields edging upwards. On Tuesday the VIX volatility index moved above 20, suggesting that the markets have become officially worried.
It is hard to say for sure what could occur if the government failed to raise the debt limit in time as it has never happened before. Indeed, Congress has successfully voted to raise the debt limit a total of 73 times since it was created in 1917. But with the nation's debt approaching an unsustainably high $17 trillion and with the Republican Party fragmented, the 74th time could be the charm.
So what happens on October 17th and the government has hit the debt ceiling? The Treasury has $30 billion left in its "checking account" and panic roams the streets. Some believe the Treasury could prioritize its spending to pay the more "important" things first and put off less important payments until the government comes to its senses and raises the debt ceiling. For example it may choose to pay veterans benefits but put off paying active duty troops.
But who is to say what is more important? Not the Treasury. It has said that it is illegal for them to pick and choose winners and that they wouldn't do it. In any case, it probably couldn't even do it if it wanted to as the government's check writing machine apparently has no way of differentiating who it is paying and when. It's as if you had 80 million automatic debits in your checking account every single day – it would be hard to stop a thousand of them, but millions? One would think that the government would have a more sophisticated payment network but apparently it just works on autopilot. Luckily, interest payments made to those holding Treasury bonds are on a separate payment system, so in theory the government could prioritize those payments over all others. While it might be illegal or unethical to prioritize interest payments over, say, social security checks to the elderly, it would avoid the nation defaulting on its bonds.
To be sure, the government would technically be in default the second it delays payment to any of its creditors -- whether it be your grandma in Kansas who didn't receive her social security check or the People's Republic of China who didn't receive the interest on its cache of U.S. Treasury bonds. But when Wall Street and the White House say they are worried about a government "default" they aren't thinking about grandma (though they should); rather, they are worried about the markets going haywire and crushing what's left of the so-called "economic recovery." If the U.S. misses an interest payment or two the fear is that the government won't be able to issue more debt at reasonable rates.
That's a big worry because the government has to continuously replace or "roll over" maturing bonds with fresh new ones every month or risk drowning in debt. This is made worse by the fact that the majority of Treasuries outstanding today have very short maturities, meaning that the government must return the money it borrowed sooner rather than later. New figures from the U.S. Treasury show that the government had to replace some $7.5 trillion in debt that matured in fiscal 2013. That was equal to a whopping 65% of all marketable U.S. debt held by the public. To put that number in perspective, the U.S. only brought in an estimated $2.7 trillion in revenue during that whole year, a mere fraction of the debt it had to pay off. This means the government needed to issue new debt to cover the old debt. The government ended up selling some $8.3 trillion in Treasuries during the year. The leftover cash went to fund the budget deficit -- yes, the budget deficit was still that big, even after the "sequester."
But if the U.S. missed a bond payment would it be the end of the world? Everyone seems to think so. Yet what if I told you that the U.S. once defaulted multiple times on its debt -- and lived to tell about it. In 1979, in the midst of another debt limit showdown, the Treasury ended up "accidentally" defaulting on a portion of its debt. In all, the Treasury missed three major bond redemptions during April and May of that year. The Treasury blamed the "mistake" on the failure of Congress to reach a decision on raising the debt ceiling. It also blamed it on technical glitches, which, judging by the launch of the health exchange websites last week, seems to still be an issue for the government in the 21st century.
The world didn't end as a result of that default but the government didn't get away scot-free, either. After the first missed payment interest rates jumped by 60 basis points and remained elevated for several months, according to an analysis of the events by economists Terry Zivney and Richard D Marcus. This meant that the government had to pay more interest than it would have normally been the case had it not defaulted. This is the terrible by-product of these government showdowns, it could take weeks or months to bring interest rates back down to earth. As a result, the U.S. taxpayer ends up paying more interest than it would have if Congress hadn't unnecessarily scared the markets. The Government Accountability Office estimates that the government paid $1.3 billion in "extra" interest in 2011 as a direct result of the squabbling over the debt ceiling that year. Over the full maturity of the bonds the government will end up paying an estimated $18.9 billion in "extra" interest, according to the Bipartisan Policy Center.
Currently, interest payments on the nation's bonds equates to around just 8% of federal revenues. That means if the Treasury plans ahead and was able to prioritize bondholders over all other creditors, it could probably cover all its debt payments and avoid a default. At the same time it also means that the U.S. could afford to pay significantly more in interest if it needed to, say, do a little default or two. Based on what occurred in 1979, it seems possible that the U.S. could put off paying its debt for a bit, allowing the government to pay grandma's social security, at least until the debt situation is worked out. It would eventually have to pay extra interest on the missed bond payments and payout an undetermined amount of interest on all future bonds to account for the increased risk in a security that was once considered "risk-free." It is unclear how much investors could earn in "extra" interest as a result of a default. The markets may shake this all off and investors could go on buying Treasuries without a hitch. But there is a chance that investors might choose to park their cash in "safer" securities and abandon Treasuries all together.
That is, of course, if the Treasury decides to put grandma first in line in front of China and other bondholders. The test will come sooner than later. After the 17th the U.S. will only have around $30 billion in its account. It receives on average around $7 billion a day in revenue from withholding taxes. That revenue, combined with the $30 billion, is all the money the U.S. can live on -- it won't last very long. At the beginning of November the Treasury will need to pay out some $17 billion to Medicare; $25 billion to social security (with another $12 billion weekly thereafter); and $25 billion for military and veteran pay, including those receiving Supplemental Security Income (SSI). On November 15th the government will have to pay around $31 billion in interest due to bondholders -- it probably won't have enough cash to cover it.
The government could then delay payments on its debt until it has the money or until a deal is worked out -- how it responds will be dictated largely on how the market responds. Beyond that, it is really anyone's guess as to what could happen next. For grandma and China's sake, let's hope we never find out.