Why We Could Really Hit the Debt Ceiling

With Congress moving like molasses and time running out, more and more Americans are wondering what happens when we hit the debt ceiling.

The short answer is that it would be bad - as in catastrophically, you've-never-seen-anything-like-this-in-your-life bad.

"[It] would be like the financial market equivalent of that Hieronymus Bosch painting of hell," Michael Feroli, chief economist at JP Morgan, told the Washington Post.

Yet many on Wall Street are convinced that even the dunderheads in Washington are not stupid enough to allow the United States to default on its debt.

That's why the markets, while a bit shaky, so far have not plummeted.

As of yesterday (Thursday), President Barack Obama was in the midst of a series of meetings with members of Congress with the idea of forging a deal that would extend the U.S. debt ceiling for about six weeks while negotiations on other budget matters continued.

News of the talks sent stocks soaring, with the Dow Jones Industrial Average ending yesterday up more than 322 points.

But that deal just pushes the next debt ceiling crisis to Thanksgiving, a period when Washington historically doesn't get much done.

And any short-term deal wouldn't guarantee a more lasting solution later over the issues that have caused the crisis - the funding of Obamacare, entitlement program reform, and the Republican goal of cutting spending in concert with raising the debt ceiling.

Because Congress has managed to conjure up last-minute deals in the past, as they did in the summer of 2011, Wall Street is confident they'll do it again this time.

But that confidence is misplaced.

You see, both the Tea Party Republicans driving this impasse and the Democrats see this as a fight they must win at all costs.

And both are convinced the grave threat of a U.S. default will force the other to surrender. In this high-stakes game of chicken, even a small miscalculation by either side could trigger the U.S. debt default that everyone fears.

"It would be insane to default, but it's no longer a zero-percent probability," Simon Johnson, a former chief economist of the International Monetary Fund, told Bloomberg.

That's why it's vital to know ahead of time what will happen when we hit the debt ceiling, be it next week, in six weeks, or however long they manage to kick this can down the road...

What Happens When We Hit the Debt Ceiling

People are worried now about what happens when we hit the debt ceiling, but the fact is we already did - on May 19.

The Treasury Department has used "extraordinary measures" since then to keep paying the nation's bills, but the bag of tricks will be exhausted Oct. 17.

That's when Treasury Secretary Jack Lew has estimated the government will be down to about $30 billion in cash.

On average the federal government spends about $10 billion a day while continuing to take in revenue, mostly through taxes. But that revenue is only enough to cover 68% of the government's bills - the rest must be borrowed. That's why Congress needs to raise the U.S. debt ceiling.

Without the ability to borrow more money, some bills will go unpaid. That list of people the government must pay includes contractors, Social Security recipients, soldiers, and, most crucially, those who hold U.S. debt.

That matters because if the U.S. fails to make interest payments on any of its debt (mostly Treasuries), it will be in default for the first time in its history.

"People have typically turned to Treasuries as a safe haven, but what will happen when they realize it's not safe anymore," Jim Grant, founder of Grant's Interest Rate Observer, told Bloomberg. "Financial markets are all confidence-based. If that confidence is shaken, you have disaster."

Things would get very ugly very quickly - take a look:

"Credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse," warns a statement from the Treasury Department.

President Obama on Tuesday cautioned that "every American could see their 401(k)s and home values fall, borrowing cost for mortgages and student loans rise, and there would be a significant risk of a very deep recession."

One Deutsche Bank analyst has predicted a debt default would cause a 45% drop in the stock market.

Why Congress Isn't So Worried About Raising the U.S. Debt Ceiling

With Treasury painting such a terrifying picture of what happens if we hit the debt ceiling, you'd think the members of Congress would do whatever it takes to avoid it.

But they think they know better.

They've deluded themselves with ideas that there are ways to avoid default even if they fail to raise the debt ceiling by the deadline.

One popular idea in Washington is that Treasury can simply use the money that's still coming in to pay the interest on the debt and thus avoid default.

Called "prioritizing," this idea is marginally better than an outright default, but not by much.

For one thing, the government's computer systems aren't designed for prioritizing; they're designed to pay the nation's bills as they come in - on time.

And changing that would be a herculean task. The government uses multiple systems that are interlinked and make nearly 100 million payments every month.

It might be possible to shut off all payment systems but the one that pays interest on Treasury bonds, but that option is of questionable legality and would mean that almost no one else would get paid - federal workers and contractors, Social Security and Medicare recipients, and so on.

Turning off the spigot of billions of federal dollars flowing into the U.S. economy would trigger an almost immediate recession.

What's more, it would still damage the nation's financial standing.

"How long do you continue to invest in the United States when you have deteriorating confidence; you see they're missing bills," a financial services industry executive told The Hill. "If we stop paying some of the things that we said we'll pay, even if we're still paying the interest on our debt, I still think people will look at us with a quizzical eye and say, 'That's a banana republic.'"

In any case, White House Press Secretary Jay Carney dismissed the idea. "Prioritization is default by another name," he said.

Another approach involves delaying payments, but as anyone behind in their bills knows, the pile of unpaid notices just keeps getting higher.

Or President Obama could just break the law and ignore the debt ceiling, or mint a $1 trillion platinum coin. But such hare-brained schemes would no doubt make buyers of U.S debt leery.

That such ideas are even discussed in Washington only encourages Congress to continue flirting with disaster.

In fact, Money Morning Chief Investment Strategist Keith Fitz-Gerald believes the brinksmanship in Washington has already inflicted serious harm on the U.S. economy.

"I think there's long-term damage, and I think it's extreme," Fitz-Gerald said. "It's extreme in terms of confidence, it's extreme in terms of lending, and it's extreme in terms of CEOs' willingness to invest. Because what's happened is that Congress has proven the fact they can't sit down and have a knowledgeable, normal, civilized, intelligent discussion. CEOs are going to look elsewhere for their revenue, and that's not going to include the United States, sadly."

The chaos in Washington can spill over into the markets at any time. Fortunately, the Money Morning team has developed several strategies for coping with what happens when we hit the debt ceiling, or if the government shutdown drags on much longer. Be sure you take steps today to protect your money...

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