Even if the US technically runs out of money, creditors will probably allow a little time before calling it a default. But investors may bail long before then. Here’s a road map to how it would play out.
The United States inches closer to a default on its debts and a downgrade of its AAA credit rating.
Talks collapsed on Friday, and ended after less than an hour on Saturday. The “new” plans floated on Sunday are really old plans that deserve a place among the walking dead.
But what does default mean, exactly? As the Greek debt crisis and the “solution” to that crisis show, very little about this process is cut and dried. And stuff that seems like it should be definite—like the term “default” itself—is actually very, very squishy.
Turns out one of the big uncertainties is how long words—which make up what I’d call the “delay and deny" defense—can keep creditors at bay once you’ve run out of money and borrowing room.
Here’s how a US default would play out.
The Phone Call
If Congress doesn’t raise the debt ceiling, the default process will begin with a phone call, sometime on or after August 2.
The Federal Reserve will phone the US Treasury and say something like, “Projecting the inflows and outflows to the Treasury’s account, the account will be overdrawn by the end of the day. Do you want to deposit more funds, or cancel some of the scheduled payments?”
This part of the process is clear-cut. The Fed is required by law to make this phone call, and by law has no wiggle room. The Fed isn’t allowed to let the Treasury overdraw its account.
What happens next, though, isn’t nearly as clear. And what the Treasury might do if it gets that call has as much to do with politics as it does with government finances.
The Treasury isn’t talking about what it might do, at least partly because the last thing the Obama administration wants to do is tell Congress it might have more time to avert a disaster. My best guess: if the Treasury’s judgment is that buying Congress a few extra days will result in a deal that avoids default, the Treasury will find a trick, or two, or three—such as borrowing from Fannie Mae or Freddie Mac—to avoid a default.
If the politics say that a few days won’t matter, and that ratcheting up the pressure on Congress by holding back on issuing government checks or delaying payments due to vendors is more important, then the Treasury will start to practice triage on the government’s obligations.
Would that be a default? As you and I understand the word, definitely.
The US would owe money to bondholders, or Social Security recipients, or state governments, or military personnel, or vendors that sold it everything from computers to light bulbs, and it won’t be sending out payments on time. It has an obligation to pay, and it wouldn’t be living up to that obligation.
But the reality is that a borrower isn’t in default until a lender, creditor, or credit-rating agency says he or she is. And it’s frequently in the self-interest of the lending party or creditor not to call a default a default immediately.
NEXT: The Greek Example