Why We Should Fear Default on Government


No matter your political stripes, I think it is important to understand we all lose if the government defaults on its debt. I fear there is an attitude that the world hasn’t fallen apart due to a government shutdown, so how much worse would things get if we defaulted on payments?

A default would be a lot worse; worse than any of us could imagine. Let me try to explain.

The debt the United States generates is considered risk-free to investors. Why? The American economy is an awesome, flexible force not matched by any other in the world. Based on our population size, no other economy comes close in terms of productivity per person, innovation and income. This means our economy is robust, and our government should have little problem collecting taxes and repaying anything they borrow. Investors do not fear that we cannot repay our debt. The problem we are facing is whether or not we want to repay our debt.

If we don’t pay our debt, or at least don’t pay timely, US debt will no longer be considered risk-free. This means investors will demand a higher interest rate on our debt for taking more risk. Why is this a big deal? It will force interest rates everywhere to go up. Interest rates are really the price of money.

To better understand the pricing model, imagine for a second we weren’t talking about money but were talking about a different product, like gasoline. Say you pull up to a gas station pump, and you see you have three different grades of gasoline. The price for the cheapest grade is $3.00/gallon. The next cheapest grade is $3.20/gallon, and the most expensive grade is $3.40/gallon. Now say there was a shock to the oil market, and suddenly the cheapest grade is $3.50/gallon. You know that the other grades are going to move up in price. You will probably see the mid-range grade jump to $3.70/gallon and the premium jump to $3.90/gallon. The point is, with US debt being the baseline for the least risk and the cheapest debt out there, if the price of our debt increases, the price of all debt will also rise. If interest rates rise on our government debt (because now it is “riskier” due to a default) debt everywhere will become a lot more expensive. Car loans, home loans, business loans or any loan will increase in price via the interest rate.

How this will affect the economy can be best understood with the simplistic model put forth by economists, which says Economic Output = Government Spending + Investments Made + Consumer Spending + Net Exports. Now, we see with sequestration and the government shutdown, that government spending has decreased. That has a negative impact on economic output. But, this hasn’t caused backwards movement of economic output. Why? Because consumer spending has increased at a faster pace than government spending has decreased. Like I said, the American economy is robust! But a default will have different consequences. This is because it will also greatly impact consumer spending.

It would be helpful to understand how much each piece of the model contributes to economic output. Here are the numbers I was able to readily find for the annualized 1st quarter of 2010 (I couldn’t use 2013 data since the government shutdown has led to a denial of access their current databases):

                Total Economic Output :   $14.6 trillion

                Government Spending :      $3.0 trillion (21% of the economy)

                Consumer Spending:         $10.3 trillion (70% of the economy)

                Investments Made:             $1.8 trillion (12% of the economy)

                Net Exports:                          -$0.5 trillion (-3% of the economy)

As noted earlier, a default will cause interest rates to rise. When interest rates rise, that will decrease both government spending and consumer spending. The government will need to use more of its funds to pay interest and will have less money to spend on public works and services. Likewise, consumers and businesses will use more of their money to pay interest and will have less money to spend on products and services. Remember, consumer spending is 70% of the economy, and government spending is 21% of the economy. That means a default will certainly impact 91% of total economic activity. A recession, which is when economic output shrinks, would result. If interest rates rise suddenly, government spending and consumer spending will drop suddenly. The immediate recession could be far worse than the housing crises we experienced 5 years ago.

How bad the recession would be will depend on how high the interest rates go. Nobody knows how high the interest rates will go. Frankly, I don’t think it is worth the risk to test it. One default will be enough to permanently shift interest rates, and the U.S. will likely never be considered risk-free again. In this sense, one default opens Pandora’s Box, and there will be no going back, as we will always be stuck with higher interest rates.

There is another idea floated which suggests the government could make its debt payments but not make domestic payments due to government agencies or citizens. This is a weak argument within the financial community. In finance, when we look at someone’s ability to make debt payments, we look at total cash flow. We expect the borrower to be able to pay all expenses and pay all debt. If we know the borrower does not have enough money to pay both, we will likely not grant them a loan. Would you give a loan to someone who argues they make enough money to pay their debt, but cannot pay utility bills and employee wages? This is risky, and that means interest rates are sure to go up in this circumstance anyway.

One certainty about the impact of increased interest rates is it will impact all of us. Unlike the housing recession that hit some regions harder than others, the increase in interest rates will infiltrate every community in America. The extent as to how much it will impact our Congressmen and Senators is harder to predict. As of 2011, the average net worth of a representative in the House is $6.5 million, and the average net worth of a Senator is $11.9 million. While members of Congress will also be impacted, it will clearly impact the average American household far worse whose average net worth is estimated to be $77,300, which is 1% of that of the average member of Congress. Perhaps this is why Congress fears the default less than us of the general public.--Trevor Plett