Last summer, a default on the US national debt was discussed and debated in DC, townhalls, and around the world. Right about now, congress is debating whether to raise the debt ceiling another trillion or two dollars. Some are saying we shouldn’t, and we should have a massive spending freeze, essentially shutting down most of the federal government.
Some are even suggesting that we should completely default on the debt — though these folks are more rare than most when it comes to politics. But it’s an important topic to understand.
If the United States defaults on its debt, it’ll have huge economic implications for both the US and the rest of the world. Depending on how the default occurs — whether through refusal to pay or through inflation — the economic impacts will also look a lot different.
To get some background information, start with the article we published a few days ago on The Truth About the National Debt. But for now, let’s talk about the different ways the default could happen.
Option 1. Literal Default.
A “literal” default means the US flatly rejects the notion of paying off debts. If this occurs, it means the US government will essentially refuse to pay back the debt. Investors in that debt — holders of short and long term treasury bonds — will get dinged hard.
Is this very likely? Possibly for a short period. It’s possible congress and the president could play chicken and we might suddenly hit the wall — but most likely only for a short time, simply because no politician in DC today has the guts to ride out an entire default. It would be much, much easier for them to go the other route — an inflationary default.
Either way, here are some likely consequences if the US federal government flat-out refuses to make payments:
- Money Market Funds. These funds have trillions in cash parked in them. A huge portion are invested in treasury bills, meaning many investors will suddenly lose money with their cash portfolios. On that note, plenty of people directly holding the treasury bills would be hurt as well.
- Stock Market Drops. The stock market would drop for a variety of reasons, not the least of which is losses inherent in a default — plus, the uncertainty would push the prices down as more and more people flood away from volatile assets looking for safe havens.
- Uncertainty Skyrockets. When the government is defaulting on the debt, that causes the bond market to go haywire, which ripples throughout the entire economy. Uncertainty is bad because businesses often hold off on projects during high uncertainty periods — this hurts economic movement and growth, further creating problems.
- Government Services Cut. During a debt default, massive cuts in spending will be necessary unless the government simply inflates its way to pay the budget. Now this is a very good thing in the long run (I’m unapologetic about my views that the government is massive and pointlessly huge — the size of the US federal government is simply insane), but in the short run it means we have to live within our means. That’ll “feel” bad to the economy, possibly pushing us toward a short-term recession. I’ll explain this in my next article “What Happens If Deficits Are Drastically Cut?”
Of course, the more realistic “default” will be a “monetization” of the debt. We’ll discuss this below.
Option 2. Inflationary Default.
An inflationary default will be similar to a traditional default, only a little different for the following reason:
- Increase in Money Supply.
Deficits slightly increase the money circulation in the US because it essentially pulls dollars in from around the world with a long-term promise to nominally pay it back, plus interest. In other words, it causes dollars to get sent in from Europe and Asia.
The amount of dollars in the world is roughly the same, but the flow is — at least in the short run — pushing those dollars toward the US. This might not cause a new net amount of inflation for the whole world, but it is slightly inflationary for the domestic economy.
However, simply printing money instead of borrowing it makes it even worse, because it puts entirely new dollars into circulation — not just money that was already printed in the past. This means that there are simply more dollars faster than otherwise — and the overall value of the currency will drop.
This means inflation will be hitting. Perhaps even worse, people will be reacting strongly to it — conservatives and libertarians have warned about this for years — and that will make the impacts even more severe.
Will this cause hyperinflation? I wrote an article about why we’re not close to hyperinflation yet, but that could very well change. It depends on how much the US increases spending. I don’t believe so — not unless something completely insane also happens, like a third world war — but high inflation will absolutely hit us hard.
This is part of my series of articles on important economic and financial topics that are often confusing. I’ve also written about the national debt, hyperinflation in America, and will soon be writing about “Quantitative Easing” and “What Happens if Deficits Are Dramatically Cut?”
If you’re already a free email subscriber, I’ll email you when these articles are done.
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