The debt deadlock: What happens if the U.S. defaults?
How a default would unfold immediately appears relatively straightforward. It's the reaction that no one can predict, because it's never happened before.
A default would have some "pretty serious ramifications" for the U.S. economy and, because the U.S. is still 20 per cent of world GDP, it would matter a lot to other countries as well, Jack Mintz, Director of the University of Calgary's School of Public Policy Studies told CBC News.
How Canada might be affected:
- If ratings agencies downgrade the U.S. government's triple-A rating, would Canada also lose its similar rating, given the integration of the two economies? "I suspect no," says Jack Mintz Director of the University of Calgary's School of Public Policy Studies. "Just like if you have a downgrade for a major company, that doesn't mean there's going to be a downgrade for every other major company." But, adds Mintz, with 75 per cent of Canada's trade being with the US, any economic slowdown there could be expected to have an effect here.
- Canadian firms relying on U.S. government contracts would wait to be paid and to learn whether they had won new contracts. On July 26, Montreal-based information technology company CGI Group, for example, said it had 150 outstanding bids with the U.S. government valued at more than $1.5 billion.
- If financial markets in the world's biggest economy panic, the contagion would spread quickly to Canada, especially given the degree to which our export-driven economy is interwoven with that of the U.S. That would affect borrowing costs, share prices and the ability of Canadian companies to raise capital and create jobs.
"You could expect higher interest rates and potential destabilization in financial markets," he said, perhaps similar to the stresses and strains which occurred in the 2009 credit crisis.
"Over the years, people looked at the U.S. economy as a relatively strong economy," Mintz said.
A default, "will certainly shape world perception about the U.S. government always fulfilling its credit and being relatively riskless, and that will make Treasury bills more expensive over time and interest rates higher."
Many U.S. businesses would also face downgrades, he said, and that would mean higher costs of capital, which would mean less job creation and less investment spending.
Fed moves first
The first move would be made by the U.S. Federal Reserve. The Fed is the Treasury Department's bank, handling government cheques and lending to banks which borrow using U.S. Treasury debt as collateral.
One day — the U.S. government has estimated it will be Tuesday — the Fed will serve notice on the government that its account at the Fed will be in overdraft by the end of the day, in violation of the Federal Reserve Act.
Next Wednesday, some $23 billion in Social Security benefit payments are due to be processed.
On Aug. 4, the Treasury Department must pay $87 billion to investors to redeem maturing Treasury securities.
On Aug. 15, more than $30 billion in interest payments come due.
In addition to those costs, the government normally pays $5 billion to $10 billion daily to defence contractors, Medicare providers, federal employees and others.
With no authority from Congress to borrow more, the government won't be able to make all its usual payments.
Some suggest the government could pay some of its bills and defer other spending, but given it makes more than 70 million payments a month, that selective payment would be a formidable task.
Government services would take enormous hit
Regardless of how that issue is resolved, there's no question that government services, programs and benefits could take an enormous hit.
No one knows exactly what spending choices U.S. president Barack Obama and his top officials would make if the crisis comes.
The White House Office of Budget and Management is the agency charged with reviewing possible cuts in benefits and payments while the Treasury Department handles cash flow.
All have been mum about their crisis plans, apparently to avoid market speculation or panic.
One analysis, by the Bipartisan Policy Center, suggested that once the government runs out of cash and lacks the power to further borrow, it would need to slash spending at once by as much as a whopping 44 per cent. The U.S. now borrows more than 40 cents for every dollar it spends.
"Some really tough decisions have to be made about who gets paid and who doesn't get paid," said Mintz. "If you keep paying bondholders, the spending cuts could be considerable."
Parks and monuments could be temporarily shut. Clinical trials on new drugs or other scientific research projects as well as half-finished highway construction projects would be put on hold.
The fear is that an extended period in default would throw the already weak U.S. economy back into recession as social services and pension cheques don't go out, civil servants don't get paid and companies that rely on U.S. government contracts and services see their revenues fall.
A recession in the world's largest economy would result in lower tax revenues for the government and a higher deficit, and affect global trade.
Federal Reserve Chairman Ben Bernanke has called the failure to raise the debt limit "a recovery-ending event."
The financial markets' reaction is difficult to gauge. It's not like the U.S. government, with its top-tier credit rating, can't find a willing lender. It's just that Congress has decided not to pay its bills. And leaders of both parties have committed themselves to raising the debt ceiling.
So investors might not view a default as serious. On the other hand, no one knows.
According to an analysis by TD Bank, it's highly likely that the first assets to be affected after a default would be money-market funds that hold government securities, banks that buy bonds directly from the Federal Reserve and resell them to consumers, including pension and mutual funds; and the foreign investor community, which holds nearly half of all Treasury securities.
As well, the currency markets would likely accelerate the selling of the U.S. dollar that has been underway recently, possibly challenging the greenback's status as the world's prime "reserve currency."
China and other countries that now hold about 50 per cent of all U.S. Treasury securities could start dumping them, said TD, further pushing up interest rates and swelling the national debt. It would be a vicious cycle, TD said, of higher and higher interest rates and more and more debt.
Possibly mitigating the rise in rates somewhat would be a move by investors to get out of the currency markets and into assets whose prices are linked to U.S. Treasuries.
Market selloff would erode savings
But if other central banks sell the U.S. dollar, what would they buy? With the euro zone facing its own debt problems and gold prices already soaring, there are a limited number of places to seek shelter.
The prospect of a slowing economy could drive a selloff in stock markets. That, in turn, would deal a savage blow to already fragile pension plans and similar retirement investments and undermine consumer confidence and the willingness to spend.
The prospect of a slowing economy should mean commodity prices would fall on speculation of lower demand, but that might be mitigated somewhat as traders move into commodities as a tangible store of value.
Will all this happen? No one knows. But JPMorgan Chase CEO Jaime Dimon has questioned why Congress would take the chance.
"No one can possibly say, in my opinion who is semi-rational, could possibly say that there's no chance of a catastrophic outcome. And therefore why would you take that risk?"
Why a U.S. debt default worries Alberta
Few jurisdictions in the world depend on investment spending the way Alberta does, according to a commentary by ATB Financial, and a large part of that investment flow comes from the U.S.
While investment spending accounted for 22 per cent of the Canadian economy in 2009, it accounted for about 32 per cent of activity in Alberta, at more than $25 billion.
Investment spending by the energy industry — on building pipelines, as an example — dwarfs every other sector. Energy investment also stimulates other sectors, such as household construction, as people who come to the province to work in the oil industry buy houses and expect schools to be built nearby.
"The point here is to highlight that events which jeopardize the energy investment flow have disastrous effects on the provincial economy," ATB Financial said in a commentary.
"A US debt default would certainly be one such event, given the calamity it would cause in financial markets and the US economy. Hopefully this is resolved soon," it said.
With files from The Canadian Press and The Associated Press