Posted October 14, 2013

The Debt Ceiling Crisis Should Scare You Because of This

By Eric Reed

 

 

 

 

NEW YORK (MainStreet) — Three days until the debt ceiling and counting.

Anyone who's been paying attention to the news lately can be forgiven for thinking the debt debate might not have much to do with them. After all, despite near-apocalyptic coverage, the conversation so far has been all about credit markets, interest fluctuation and investor confidence. It's perfectly reasonable of most Americans to view this as just another Washington kerfuffle and respond accordingly: yawn then get back to work.

If only it were so.

Unfortunately, like the ongoing shutdown fight, a crisis over the debt ceiling is something that everyone would eventually feel. Largely this is because of the much-misunderstood nature of Treasury borrowing, which creates creditors but no new debt. The agency raises money to pay previously authorized bills, such as for military contracts, salaries or doctors' bills under Medicare. Since the agency borrows only to pay existing obligations, the amount the government owes never changes.

The debt ceiling is about transferring debt, not creating it.

Because of this, the debt ceiling doesn't change how much America spends but whether the government pays its bills. Default would cause a ripple effect across the entire economy, starting with credit markets that depend on the timely payments of Treasury bonds. Economists argue about what the precise fallout would be, since an intentional government default has never happened before in the United States.

At best, the result would shake an already tenuous economic recovery. At worst, interest rates would climb, credit would freeze, lending would grow scarce and we could be looking at another 2008.

For those of us at the ground level, the first casualty would be employment.
"If the credit market freezes up all of a sudden, businesses are not going to have access to money," explained Thomas Hungerford, an economist with the Economic Policy Institute. "So small businesses and startups are not going to be able to get credit to expand or to hire."
"A lot of large businesses, they fund their investments more through debt than equity," Hungerford added. "If people don't have access to loans, they stop buying durable goods. That kind of dries up. Well, who makes durable goods? Our manufacturing sector. If they're not selling, they lay off workers."

Without access to credit, new businesses won't have the money to hire or keep employees through lean times. Existing ones will lose the resources to expand, or may decide to hoard cash in a defensive huddle and shed salaries to do so, as many did during the last recession.
What's more, companies without credit lose purchasing power. As sellers lose business, they could lay off even more workers, who in turn then lose purchasing power at the individual level. Together it creates the vicious cycle of an economic recession, all starting at the top. An electrician with absolutely no stake in the market can still lose his job, because a business failed to open when it couldn't get a loan. When it comes to the economy, were all in this together.
Interest rates could also go up across the board.
"If we had a deliberate breach, if we just defaulted at least temporarily on our bonds, interest rates could go up," Hungerford said. "And people are going to see that in their already-too-high interest rates on credit cards, their auto loans, things like that which could go up."

It may seem bizarre that the interest on your car payment could rise because somebody else failed to pay their bills, but that's what happens. Commercial interest is often pegged to a central rate known as Prime. Generally a loan (such as a credit card or homeowner's loan) will have an interest rate set to Prime plus "x." That central rate, according to Hungerford, fluctuates based on the interest payments on what the market considers riskless assets.
Chief among them? Treasury bonds.

"A lot of things are linked to the rate of return on government bonds one way or another," Hungerford said. "So if we end up defaulting... in order to entice people to buy our bonds, we're essentially going to have to offer them a higher rate of return or a higher yield."
This is because interest goes up as an asset becomes riskier, offering investors a higher return as incentive to take on the extra risk. So if timely payment is no longer assured on Treasury bonds, interest on them will rise. They'll take the Prime, and therefore the rest of the marketplace, with them, and just like that, we're all paying more for our student loans.
Direct payments will drop off too, sucking cash out of the economy at a very perilous time.
It bears repeating that the debt ceiling isn't just about making sure that investors and foreign governments get their loans repaid. The U.S. government owes far more money to its own citizens in the form of bills for services, purchase agreements and entitlement checks. If the government breaks its debt ceiling, it won't be able to honor those agreements, leading to a nation of doctors, engineers and retirees who suddenly have a lot less money to spend.

"Some of the immediate effects, it depends on what we can and what we can't pay," Hungerford said. "November 1, we're supposed to be sending out Social Security checks. Are we going to be able to cover that? Doctors getting repaid for Medicare, that could be affected immediately. Then just paying off government contractors, paying off our bills for goods received; some things we'll be able to pay, some things we won't and that's going to end up affecting businesses."
"If it's going to be a long delay," he added, "firms are going to start laying off workers."

Like a credit crisis, if the government suddenly stops paying its bills, there'll be a massive vacuum in the American economy. Companies that depend on those contracts could start laying off workers to make up for the lost revenue, and individuals might start having to cut back to make up for lost income, leading to the vicious cycle of recession where consumers can't fuel business which then can't employ consumers.
Exactly how bad this could get remains to be seen. As Hungerford mentioned, there is simply no precedent for an intentional, modern default.
"Under what I would consider the best scenario, we'll end up seeing higher interest rates," he said. "If it goes on and the credit markets seize up, it could throw us back into another nasty recession. And we are starting out at an unemployment rate that's over 7%."
Beyond the politics and the talk of high-finance market fluctuations is the price that will be paid by voters on the ground: unemployment, soaring interest and insecurity. While the terms of the debate may seem vague and academic, the impact will be anything but.

If you're not scared by now, you're not paying attention.

--Written for MainStreet by Eric Reed, a freelance journalist who writes frequently on the subjects of career and travel. You can read more of his work at his website www.wanderinglawyer.com.

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