smart spending

Debt ceiling: What if it's not raised?

Young couple stressed over bills © WavebreakmediaMicro / Fotolia
Highlights
  • The debt ceiling is the total debt that the government is allowed to incur.
  • At some point, the government would be considered in default.
  • A default could cause a credit freeze on consumer loans, among other things.

Fresh off of a last-minute resolution to the so-called fiscal cliff, it's tempting to tune out noise about another standoff in Washington, D.C. But the fight over raising the debt ceiling could have hard-to-ignore effects on your wallet if it drags on too long.

The debt ceiling, also known as the debt limit, is the total amount of debt the U.S. government is allowed to incur. The federal government already has hit that limit. Because the U.S. is committed to spending substantially more than it's currently collecting in taxes and other revenue, the fallout for consumers could be severe if Congress fails to raise the limit in time, says Robert Dye, chief economist at Comerica Bank.

"Congress and (President Barack Obama) are playing with fire," Dye says.

A bill to postpone the threat of government default until May 19 has passed the House and is expected to pass the Senate. But if legislators again fail to pass a real debt limit increase, the drama will unfold in three phases.

Phase 1: The Treasury tap dance

In this first phase, which began with the United States hitting the debt ceiling in mid-January, the government is still paying most of its bills thanks to some creative accounting by the Treasury, Dye says.

"Technically, we're over the debt limit," he says. "The Treasury has undertaken what they call 'extraordinary measures.' These measures cannot run forever. There are time limits to these."

The effects of reaching the debt ceiling at this point are hard to quantify, but they may already be putting a slight drag on the economy, says Phillip Wallach, a fellow in governance studies at the Brookings Institution. He cites the Economic Policy Uncertainty Index, which spiked during the last debt ceiling showdown and is now climbing again.

"Businesses are extremely unsure about the near future, just because of these fiscal negotiations sort of casting a shadow over everything," Wallach says. "As a result, they may be delaying hiring decisions, delaying capital purchases, basically waiting until they know more, and that has some potential to cause some drag on the economy."

Darrell Duffie, professor of finance at the Graduate School of Business at Stanford University, says most Americans at this point probably won't notice anything amiss beyond some noise in the press. "They probably won't feel it personally unless they are expecting a check from the government that might get caught up in any debt ceiling slowdown," Duffie says.

Phase 2: Prioritization

Sometime around the middle of February to the beginning of March, referred to by policymakers as the "X Date," the ability of the federal government to meet its obligations will deteriorate to the point where some of the government's bills will simply have to go unpaid, Dye says.

If it turns out to be legally and technologically feasible for the Treasury to sort out the more than 80 million different payments every month, Duffie says the Obama administration may try to create an order of priority for who will get paid and who won't.

Under such a prioritization program, interest payments on U.S. debt and essential services such as national defense and air traffic controllers would probably continue to be funded as well as critical government benefits such as Social Security, Duffie says. But payments to government contractors would likely get the short end of the stick, and nonessential government workers could see themselves furloughed.

It's impossible to know with any certainty how that prioritization process would play out, so if you depend on the government for benefits or a paycheck, it may be prudent to stash away a little extra cash to cover expenses, Duffie says.

Even those who don't receive any money directly from the government would begin to see the effects of the debt ceiling standoff begin to creep into other areas of their financial life, as government spending and reduced economic confidence begin to take their toll, he says.

One place that consumers might notice it is in their retirement accounts, Duffie says. A prolonged struggle over the debt ceiling could trigger a decline in stock prices as global investors became increasingly skittish over the prospects of a U.S. default.

On the bright side, interest rates on consumer loans could head lower as global investors retreat into cash and safe investments, including paradoxically U.S. Treasuries, says Michael Goldberg, Roland H. O'Neal professor at the University of New Hampshire Whittemore School of Business and Economics.

"The last time we got close to this debt ceiling and (Standard & Poor's) downgraded U.S. debt, the interest rates that we had to pay on U.S. Treasuries went down," Goldberg says. "There doesn't seem to be a good substitute for U.S. Treasuries."

However, Goldberg says that could change quickly as the U.S. edges closer to the next phase.

Phase 3: Default

Wallach, of the Brookings Institution, says if no deal is reached, the government will eventually become unable to service its debt. At that point, the government would be considered in default. Such a default, which would include failing to make interest payments on Treasuries treated as "risk-free" by international markets, would be an economic disaster.

"It would send shock waves throughout the world economy and consumers, you can bet, would feel that pretty quick," Wallach says. "It would start to feel like September 2008," when the investment bank Lehman Brothers filed for bankruptcy protection.

From there, experts say Americans could expect to see some or all of the following.

  • A substantial drop in stock prices.
  • A credit freeze that makes it difficult or even impossible for many borrowers to get loans for homes, cars and other purchases.
  • Mass layoffs as businesses look to cut costs or close their doors thanks to an inability to access adequate lines of credit.
  • A spike in Treasury yields that could drastically increase the cost of borrowing for those who could still qualify.
  • A reversal of gains in the housing market as consumer credit dries up.
  • A decline in the value of the dollar.

"Things just get very ugly, very quickly. As a result, you can expect that the impasse wouldn't really last very long," Wallach says. "Because suddenly this goes from being something that people who pay a lot of attention to politics are tuned in to, to something that every single person who has any kind of political consciousness is trying to fix."

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