What Happens If Congress Can’t Make A Deal On The Debt?

If you don't pay your electric bill on time, you'll probably get charged a buck or two in interest. As long as you pay off the balance in a reasonable amount of time, your lights will stay on.

So why is it such a big deal that the Treasury Department may soon be unable to pay all of its bills on time?

U.S. Treasury securities are used as both currency and collateral for countless financial transactions around the world. Think dozens per minute.

Right now, Treasurys are almost as liquid and secure as cash. If investors are at all nervous that they might not be honored, this could have a cascading effect that will cause stock markets to tumble, the dollar to lose value and unemployment to rise.

"If Treasury bonds were no longer seen as risk-free, that would have implications for virtually all collateralized loans, which is a huge proportion," says Phillip Swagel, a University of Maryland economist who served as assistant Treasury secretary for economic policy under President George W. Bush.

"If people couldn't hold Treasurys, they would have to hold a lot of cash," he says. "We don't want people to feel like they have to hoard cash to make transactions."

Still A Big 'If'

Note that Swagel is still using the word "if." No one knows whether time will run out on the Treasury Department's authority to raise money.

Technically, it ran out in May, but the department has been able to keep juggling since then. The nominal deadline Congress and President Obama have been working with is Thursday, when the Treasury says it will be unable to borrow any more money by issuing bonds.

There's been a lot of debate about whether breaching the debt ceiling spells real trouble. In theory, Treasury can prioritize paying bondholders over other obligations — the so-called Pay China First strategy. Treasury says it lacks the software and expertise to pull that off, even if the administration decides it wants to.

It's possible that, just using daily incoming tax receipts, Treasury won't really run out of money until Nov. 1, when, among other things, Social Security recipients will be expecting their checks.

But economists are worried that even if Treasury doesn't default on any bonds right after midnight on Thursday, financial markets will grow extremely wary. Already, it costs more for Treasury to borrow money on a short-term basis than for, say, 10 years. Normal prices are inverted because investors are nervous about being paid back over the next month or so.

The date to worry about, in other words, may have nothing to do with Treasury's own drop-dead date and everything to do with when investors start panicking because they don't believe a solution will be hammered out in time.

No one can predict exactly when that would be. It's not in red on the calendar, like how many shopping days until Christmas.

But once panic sets in, things will go bad quickly.

"Markets could go into bedlam," says Mark Zandi, chief economist with the research firm Moody's Analytics. "I don't know that we have to go to Nov. 1 before there's chaos."

2008 All Over Again

It could be like 2008, only worse. Back then, the collapse of the brokerage firm Lehman Brothers triggered financial panic and a stock market crash.

The reason was that lending became extremely tight because investors became wary of most types of collateral. Why lend money based on a firm's assets if you couldn't trust those assets still had value?

The one thing that kept lending going at all, in fact, were Treasurys. They were seen as highly liquid and perfectly safe and reliable.

That's what's being put at risk in the present situation. If Treasurys are not seen as rock-solid, panicky financial markets won't know where to turn. All manner of transactions would be put on hold.

"If Treasurys should become the point of concern, not only would you have a huge problem in terms of undermining the critical linchpin of finance, but what's worse is you couldn't solve the problem by adding Treasurys, which is what we did [in 2008]," says Jason Seligman, a former Treasury staff economist who teaches at Ohio State University.

Dollars themselves would lose value, because Treasurys have to be purchased using U.S. currency. If there's less demand for Treasurys, there will be less demand for dollars.

"The entire financial system of the U.S. and the world is anchored in the idea that the government is good at paying off debts," says Matthew Shapiro, a University of Michigan economist.

The Country That Cried Wolf

Everyone is worried about how this would all play out over the coming weeks and months. If there is a debt default, a recession seems all but guaranteed.

But even if there's not — even if there is some last-minute deal that at least punts the problem a few weeks or months into the future — the fact that Washington is again cutting things so close could have lasting repercussions anyway.

Remember, when Congress flirted with not lifting the debt ceiling back in 2011, it wasn't until after lawmakers had cut a deal that the U.S. bond rating was downgraded.

It might not take a formal downgrade from a rating agency to make investors more skeptical about Treasurys.

Back in 1979, there was an almost inadvertent bond default that had to do with Treasury's back-office functions not being able to get up to speed in time following another game of debt-ceiling chicken. Even failing to pay off a fairly small amount of bonds for a brief period of time significantly raised the amount of interest Treasury had to pay creditors for some months.

"We thought there was nothing safer than Treasurys, but we're basically inviting ourselves to be regarded by financial markets as risky, as a country that doesn't keep its promises to pay," Shapiro says.