Right now, a lot of mainstream sources are focusing on the worst-case outcome in the debt ceiling standoff, which is an outright default on government bonds. Their concern is understandable: a fullblown default would be apocalyptic -- an extinction-level event for the financial markets.
But the focus on bond default has created something of a backlash: commentators coming out of the woodwork to point out that the US is extremely unlikely to actually default on bonds. They point out that interest and bond payments are a small fraction of tax revenue, paying them would be top priority for Treasury, and so even if the debt ceiling remains untouched, a default is not in the cards.
These experts right about the details, but the overarching message -- invariably some version of "Things aren't as bad as they seem, calm down" -- is wrong and misleading. No, the US isn't going to default in the old-fashioned sense. Bu there are plenty of things that can go horribly wrong in the absence of a formal default.
First, there's the possible downgrade of the US debt rating. There's been a lot of effort to put a price on a debt downgrade -- $100 billion a year has been kicked around -- but really, if people were being honest, I think they'd say that nobody has any idea what sort of ripple effects it would create. It's possible that a downgrade would be ignored, because people don't rely on rating agencies to educate them about the desirability of US debt. On the other hand, it could set off a chain reaction, when the ratings of US cities and municipalities get downgraded as well. And there could well be -- in fact, there likely are -- additional effects down the chain that nobody has dreamt up yet. US debt is a foundational brick of the world economy, and if you weaken it just a little bit, everything that's built on it might start to weaken and crumble as well.
But everybody already knows there's a possibility of downgrade, even if they're being too sanguine about it. There are other problems -- genuinely frightening possibilities -- that hardly anyone is talking about. For instance, if we blow past the debt ceiling without a deal, well over a hundred billion dollars will get yanked out of the US economy immediately, as the government stops paying its bills in order to keep paying its creditors. The result? An almost instantaneous recession. Does anyone really believe that a second recession right now -- with employment still over 9% -- would be anything less than catastrophic?
And then there's the way an economic crisis can quickly become a political crisis. A major economic downturn would only benefit the Republican Party, whose strongest card against Obama is and always has been the unemployment rate. Nevermind that the party has made literally no attempt to increase employment -- nobody votes for incumbents when the economy is bad enough. Judging from the damage that 80 or so Tea Party Republicans have done to the country and to the political process in half a year, can you imagine how much damage they could do if their ranks doubled and they took over the White House? Even if we disregard the effects of the then-inevitable gutting of American civil society, the further paralysis and radicalization of the political system would not be well-received by creditors.
Through it all, the deficit -- the ostensible cause of the crisis -- would actually increase. Another recession would lower tax revenues even further and make medium-term budget math even uglier. Likewise, a debt downgrade would add billions, if not trillions, to the national debt by increasing the cost of borrowing. And that's ignoring the knock-on effects, which are potentially far more severe: if the fiscal health of the states and municipalities gets bad enough, the federal government will eventually have to step in and start picking up the tab.
So yes, the US isn't going to default. Not in 2011. But that doesn't mean the murky, uncharted territory waiting for us past August 2 isn't terrifying.
And further into the future, who knows? Fast-forward five years. The government is straining to cover the obligations of states and cities. The economy is in the dumps. Tax revenues have collapsed. Congress is infested with Bachmannite Tea Party Republicans and the GOP controls the White House. That's a world in which it would be a little bit harder to laugh off talk of default.