Failure to raise debt cap would shock US economy

WASHINGTON – The US economy faces a shock worse than the 2008-2009 financial crisis if the government fails to raise its borrowing cap before August 2, analysts and officials say.

While attention has focused on the possibility of an unprecedented US default on its debt, economists say the government is more likely to slash spending come August 2, the day spending needs surpass receipts.

And at the current size of the budget deficit, that could mean cutting 40 percent — shutting down much of the government, halting paychecks to soldiers, closing courts, or delaying social security payments to seniors.

“That would be really catastrophic,” said Michael Ettlinger of the Center for American Progress.

Ettlinger says if the debt ceiling remains frozen through September, it would force a quarterly economic contraction over more than two percent — worse than the worst quarter in the 2007-2009 US recession. In that quarter alone, two million jobs were lost.

Whether the government chops spending or reneges on debt payments, it would be a disaster, he said.

Washington already reached its $14.3 trillion borrowing ceiling on May 16, as the stubborn political impasse over a long-term deficit plan has prevented raising it.

Through a mix of operational changes at the Treasury, the government bought some time. But in less than three weeks, something has to give: commitments will outpace receipts, and no new borrowing will be allowed to cover the gap.

“The Treasury has no secret bag of tricks to finance government operations past August 2,” the independent Bipartisan Policy Center said in a report this week.

The center says the Treasury will have to stop 40-45 percent, or $134 billion worth, of the 80 million monthly bills it pays.

If it sticks with servicing its debt, paying social security and health benefits, military contractors and unemployment insurance, it would still have to shut down the Justice and Labor departments, road-building, veterans affairs, health research, small business support, and a slew of other operations.

Such cuts, Federal Reserve chairman Ben Bernanke told members of Congress this week, would be like the Great Recession all over again, with massive layoffs — even while 14.1 million Americans are already unemployed.

Some politicians have suggested the Treasury could prioritize by suspending some debt repayment.

Bernanke, bond rating agencies, prominent banking figures, and even the International Monetary Fund have warned that such a default would be a financial disaster on global terms.

But even on a practical basis, that would be near-impossible.

The Treasury would normally have to roll over about $500 billion worth of debt in August, as well as raise new money to cover the projected $134 billion spending shortfall.

If worried markets balk, it will still either have to pay more for the debt rollovers, or go without it — and slash budgets.

The first test will be on $60 billion in Treasury the bills maturing on August 4. A few days ahead, it will have to hold new auctions to replace those.

Normally demand is strong, as show by the near-historic lows on Treasury yields right now.

But, Treasury Secretary Timothy Geithner told a senior US senator in a letter recently, if the debt ceiling is not raised by August 2, “there is no guarantee that investors could continue to re-invest in new Treasury securities.

“In fact, some market participants have already indicated that they would be disinclined to do so.”

Even if rollovers go smoothly during the first two weeks of the month, and the government cuts spending elsewhere, a test will come on August 15 when the government has to find the funds to make $25 billion in coupon payments on longer-term debt.

If it cannot do that, it will default — and suddenly, as Greece, Portugal and other debt-laden countries have found, borrowing becomes too pricey to afford.

Ian Shepherdson of High Frequency Economics says the government will shut down operations before it ever defaults on debt.

“Let us be clear… the US is not going to default on its legal obligations to the holders of its debts.”

Instead, he said, “the US is going to have to default on the pledges made to its own citizens.”

But within a few days of a shutdown, irate Americans will besiege their representatives, he predicts, and the sheer force of voter power will scare even the most dogmatic of lawmakers to help push through a hike in the debt ceiling.