What if the U.S. Fails to Reach Debt Limit Deal?

Most analysts believe U.S. lawmakers will ultimately arrive at an agreement to lift the $14.3 trillion debt limit in time to avoid defaulting on upcoming interest and debt payments. And just in case the two sides need a little encouragement or reminder of the potential consequences should they fail to arrive at a deal, Moody’s Investors Services and Standard & Poor’s have both served notice that the U.S. is under credit review pending the outcome of the discussions.

The warnings come as representatives from both the Democrats and the Republicans continue to hammer out an agreement to pave the way for the government to borrow beyond the existing debt limit. The Treasury Department has named August 2nd as the deadline, warning that failing to act before this date will leave the country without sufficient funds to meet upcoming debt obligations. After this date, the government will effectively be broke and have no option but to default.

On Wednesday, Federal Reserve Chairman Ben Bernanke used part of his appearance before the Senate Banking Committee to encourage federal lawmakers to get a deal done before the Treasury Department’s cut-off date. Bernanke told the committee that should the Treasury default, the action would send “shockwaves” throughout the global economy.

But what if a deal is not made in time? What would Bernanke’s “shockwaves” look like?

For starters, America’s credit rating would immediately be downgraded to reflect the new “default” status. The government would still have to borrow to cover its operational deficit but with the loss of it’s triple-A rating, borrowing costs would increase dramatically â€" assuming historical lenders including China, Japan, and Britain would still be willing to bankroll the country. The alternative would be a combination of steep tax hikes and deep spending cuts to cover the shortfall.

The increased costs for the government to borrow money would soon trickle-down to the consumer level thereby increasing the cost to borrow money for everything from dishwashers to automobiles. The implications this would have on an already nervous consumer goes without saying but there is little doubt the economy would soon be heading for another recession.

As cash becomes scarce, banks may become unwilling â€" or perhaps unable â€" to lend as institutions with cash may simply “go to ground” in an attempt to ride out the storm just as they did during the credit crunch that helped spark the last recession. Global stock markets would certainly fall and savers would in short order find their investments decimated.

For now, the prevailing belief is that U.S. lawmakers will do what is necessary to avoid a default. There is just too much at stake to allow politics to trump reason.

However, even if the debt ceiling is lifted in time to prevent a default, there will almost certainly not be a comprehensive plan outlining the steps the U.S. will take to close the deficit and eventually tackle the debt. A “business as usual” approach will no longer be received favorably by investors who are looking for more clarity on how the U.S. intends to deal with its chronic budget shortfall.

For this reason, and even if a default is avoided next month, there is still a possibility that investors will demand higher yields in future bond auctions due to the higher risk now associated with U.S. debt.

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