What if the Government Defaults?


The deal recently reached by Congress and President Biden suspends the debt ceiling until January 2025 in exchange for modest limits to increases in discretionary spending over the next two years. The deal will do almost nothing to reduce the federal deficit, guaranteeing that in January 2025, we will go through this charade again.

When the debt ceiling is reached, the government can no longer borrow. Portions of the $31.4 trillion national debt routinely come due, and the government borrows to repay this and make interest payments on the rest. Not being able to borrow means the government would default on these payments. Given the massive level of deficit spending, the debt ceiling is an issue that pops up on a routine basis. The question is often asked, what would happen if the government defaulted?

Banks hold approximately $2 trillion of government debt as assets on their balance sheets. Government debt holds value because the government promises to repay the face value of the debt (the principal), along with interest. If the government fails to make these payments, then the value of this debt falls to zero. Two trillion dollars in losses would push many banks into insolvency, meaning their assets are less than their liabilities. Practically, this means that banks would be unable to repay deposits. In ordinary times, the Federal Deposit Insurance Corporation (FDIC) would repay depositors if a bank fails, but the FDIC would quickly see its funds depleted. Congress would be unable to bail out the FDIC since doing so would require further government borrowing. Bank insolvencies in the event of a default would dwarf what occurred during the 2008-09 financial crisis.

Widespread bank failures would freeze credit markets. Corporations would be unable to borrow, and many would fail. Credit cards would likely stop working, as well. Pension funds, which hold nearly $1.5 trillion in government debt, would be unable to make pension payments. The economy would be plunged into a deep recession. The stock market would crash, millions (even tens of millions) of people would lose their jobs and the government would have to cut all spending that it cannot pay for using tax revenue. Since tax revenues would plummet in the recession, the government would likely cease all operations other than making Social Security and other entitlement payments and paying for national defense (though even that would likely see reductions).

The consequences of a default would be so catastrophic that no one really believes that a deal will not be reached in one of the routine debt ceiling fights. However, at some point, the $31.4 trillion (and counting) national debt will need to be repaid and lenders will start to question the government’s ability to do so. If lenders then stop loaning the government money, a debt ceiling is hit that Congress cannot increase, making the scenario I outlined a reality. Responsible federal budgeting would get the deficit under control before this occurs; but no responsible budgeting is anywhere in sight.  


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