How Costly Would a U.S. Default Be?

Monday June 27th, 2011   •   Posted by Emily Skarbek at 10:05am PDT   •  

Discussions of a Treasury default all share one common feature�no one is certain as to what a default would actually entail. A recent article in The Economist highlights a study by Terry Zivney (Ball State University) and Richard Marcus (University of Wisconsin-Milwaukee) that looked at the last instance of U.S. default in 1979. The default occurred when the Treasury failed to redeem $122 million of Treasury bills on time, blaming unprecedentedly high interest, delays in raising the debt ceiling and a word-processing-equipment failure. The Treasury ultimately repaid repaid the money with penalty�but the default was costly. The authors estimate that the default “caused a 60-basis-point interest-rate premium on some federal debt.” The Economist estimates that today those costs would be nearly $86 billion a year or 0.6% of GDP. Moreover, the article suggests a current default would “attract more attention, affect more debtholders and reach more deeply into the financial system”.

The article reports that:

Even if Congress were to tackle turmoil by quickly lifting the debt ceiling, the stain would linger. �In the past our assumption was interest would always be paid on time,� says Steven Hess of Moody�s, a ratings agency which has cautioned that even a brief default would cost America its coveted AAA status. �If an actual payment were missed once, might that happen again? If you thought it could, that is clearly not compatible with AAA.�

Underlying all of this uncertainty is the knowledge that the budget shortfalls are real, growing, and the problem is not going away. The Republicans, by insisting the U.S. government’s credit rating is what is at stake, are pushing hard to show that the fundamentals are what matter. We cannot tax our way out of the fiscal dilemma facing the country. A study in late 1980s by Richard Vedder and Lowell Gallaway for the congressional Joint Economic Committee found that every new dollar of new taxes led to more than one dollar of new spending by Congress. Subsequent revisions of the study over the next decade have found similar results. Raising taxes simply allows for more spending.

Political pressures will mount and the tendency is to roll over obligations into the future. The nature of politics will generate some “compromise” which will serve the interests of politicians and be costly for taxpayers and future taxpayers. Guaranteed�Americans are going to be dealing with the debt for years to come.

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June 2011