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US default would be ‘disastrous’ to struggling economy, analysts say

By Jay Fitzgerald
Globe Correspondent / July 10, 2011

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What would happen if the US government defaulted on its debts?

The short answer: You really don’t want to know.

While White House and congressional negotiators reconvene today to try to make a deal to raise the federal government’s legal debt limit, economists are warning of possible catastrophic consequences to the economy if an agreement isn’t reached and the nation defaults on its debts next month.

“It’s the type of thing that could trigger another recession,’’ said Nariman Behravesh, chief economist at IHS Inc., an economics research firm in Lexington.

“There would be an almost crisis of confidence, throwing the financial markets into turmoil.’’

The US government for years has spent more than it collects in taxes, leading to annual budget deficits financed by borrowing. Raising the debt limit, which allows the country to pay its creditors as well as finance government operations, has historically been a relatively routine procedure.

But with the national debt approaching $14 trillion and Washington riven by intense partisanship, the vote to raise the debt limit has been anything but pro forma. Republicans, who control the House of Representatives, have threatened to reject raising the limit unless Congress and the Obama administration drastically cut spending.

The technical default that would occur would send the interest rates the US pays to borrow in the bond markets soaring, analysts said. The rates on 10-year Treasury bills, now at about 3.1 percent, would jump as high as 5 percent, said Behravesh.

Rates for home mortgages, corporate bonds, credit cards, auto loans, and other forms of credit would quickly follow, jacking up the cost of borrowing and choking off capital to many businesses and individuals. All that would happen when the nation’s struggling economy remains especially vulnerable to shock.

“A default would be disastrous for the financial markets, the economy and, for most people, it would further harm the jobs market,’’ said Mark Zandi, chief economist at Moody’s Analytics in West Chester, Pa.

Most political observers and economists believe Democrats and Republicans will raise the borrowing limit before the nation hits the $14.3 trillion debt ceiling on Aug. 2 and loses its legal authority to borrow money to pay for federal programs.

“At its core, this is a political issue,’’ said Thomas Luster, director of investment-grade fixed income at Boston’s Eaton Vance Corp.

“[Lawmakers] know what’s at stake, so I would put a low probability on a default happening,’’ he said.

Luster, whose firm specializes in bond investments, noted that markets have signaled, through today’s relatively low interest rates, that they believe a debt-ceiling deal will be reached.

But if the political battle drags on for many more days, he said, it could unnerve some investors, bumping up interest rates and harming the economy.

“There’s no question that this does not help the confidence of investors,’’ he said.

If the worst-case scenario does unfold, and lawmakers fail to reach a debt agreement, the Treasury would have a number of options to keep paying bills, none of them attractive.

The Treasury has signaled it will do everything possible to maintain payments to investors holding trillions of dollars in US bonds, technically averting a default by using revenue from regular tax collections to pay off debt holders.

But since it legally couldn’t borrow money to pay other government bills, Treasury might have to reduce or temporarily halt expenditures on Social Security, Medicare, and other popular federal programs.

Moody’s Zandi thinks such a “payment prioritization’’ wouldn’t calm markets.

“Bond investors,’’ Zandi said, “would start asking, ‘How long will it be before Treasury feels pressure to pay off Social Security and other programs and cut our bond payments?’ ’’

Alasdair Roberts, a professor of law and public policy at Suffolk University Law School, thinks President Obama, a Democrat, and Republican congressional leaders will ultimately forge some sort of deal.

But, he said, the American public better prepare itself for future economic uncertainty and political fights related to the government’s debt, projected to exceed the nation’s economic output this year.

“This summer is a small taste of what we’re going to face in future years,’’ said Roberts, now writing a book on America’s financial crisis of the 1840s.

“We’re moving into a new phase of American economic history when international markets will be increasingly scrutinizing our finances,’’ said Roberts.

“It’s a more global economy whose rules are not yet set.’’