So We Default. What Happens Next?

Months of wrangling with still no agreement on terms leaves little time until August 2, when Treasury Secretary Tim Geithner says the U.S. will not be able to pay all its bills. So it's time to think about the unthinkable - the United States of America defaulting on its debts.

Let’s go back to September 29, 2008. The news channels watched on one side of a split screen the failing vote in the House of Representatives for the $700 billion financial bailout, while the other half of the screen tracked the Dow Jones index plunging 777 points in reaction. Two-thirds of Democrats had voted for the bailout, but only one-third of Republicans. It missed by 13 votes. The Bush administration desperately re-submitted the bill. On the second try, it passed.

If you’ve ever wondered what might have happened had there been no bailout, you might soon have that opportunity. This time it won’t be bank credit that will seize up, but the country itself. August 2 is when the federal authority to borrow reaches its limit. Geithner says the nation will run short of money if Congress doesn’t raise the debt ceiling above the current $14.3 trillion. By law, the government cannot spend or obligate itself beyond that dollar sign.

Raising the debt limit usually passes without notice. During the George W. Bush presidency, the limit was raised seven times without incident (twice in 2008). But since 2008, Republicans have gained 63 seats in the House; 28 of them are Tea Party candidates bent on little other than shrinking government by slashing spending and enacting still more tax cuts. In return for raising the debt limit, they are pressuring the Republican leadership to demand that the Obama administration cut $2 trillion from the budget 10 years.

Moody's has already issued a warning that if the debt limit is not increased, it would consider downgrading U.S. credit. Politicians on both sides blame each other for the continuing impasse.

Government spending has already bumped up against the debt limit, but Treasury’s financial shuffling has bought time until the checks finally bounce in mid-summer. At that point the government would use its funds to the extent it can prevent the country from going into default with other nations, a catastrophe that would cause the collapse of the dollar, soaring inflation and a worldwide panic. The Treasury will instead need to shortchange domestic spending: seniors will not receive social security checks, student loans will be suspended, military pay held up, and more. The panic will be here at home.

But it’s worse. The standoff a few months ago, with a government shutdown in the offing, was resolved with a last-minute $38.5 billion cut in spending. It didn’t bother Wall Street that the government might turn off the lights for a while. But the stakes this time are far higher; this has never happened before and the consequences could be seismic. If the political parties do not show progress and instead engage in brinksmanship right to the cliff edge, then well before any last minute theatrics, the bond market is likely to be spooked. If our politicians, stuck in their intractable positions, do not show progress and flirt with United States default, markets around the world could spin out of control.