The president has said that Social Security checks may not go out if a debt deal isn't struck. Default could 'sink the whole boat'

The warnings are apocalyptic. “Armageddon,” President Barack Obama intones. “Catastrophic,” Treasury Secretary Timothy Geithner insists. “Calamitous,” Federal Reserve Chairman Ben Bernanke admonishes.

But suppose — just suppose — the unthinkable happens: Despite all the talk of deals — small, medium or large — and of clever ways to pass the political buck, Congress and Obama can’t agree on legislation to raise the $14.3 trillion debt ceiling before the U.S. government’s credit line runs out around Aug. 2.


A few prominent Republicans, such as Minnesota Republican Rep. Michele Bachmann, a presidential candidate, say nothing much would happen and blast the administration for its “scare tactics.”

But financial experts say hitting the debt ceiling or coming really close to it would destabilize the markets and the economy. Just how dire the consequences would be is difficult to predict, but many Americans could feel the impact almost immediately.

Stock markets are almost certain to drop sharply. Some analysts say interest rates for Treasury bills and private borrowing would rise abruptly. Others say the flight to safety might actually make investors dump stocks and buy Treasury securities in the short term.

The first major hurdle comes on Aug. 3, when the U.S. government is scheduled to pay $23 billion in benefits to Social Security recipients. Only $12 billion in revenue is expected that day, leaving the Treasury $11 billion short — and $20 billion in the red when other scheduled payments for that day are taken into account.

Obama said in an interview with CBS News last week that he couldn’t guarantee Social Security payments will go out, a statement that could send retirees and disability recipients into a panic.

“I’d say it’s at risk,” said Jay Powell, a former senior Treasury Department official now with the Bipartisan Policy Center. “The president’s statement is correct on its face. He said he can’t guarantee those payments will be made. Even if you pay nothing other than interest, you can’t guarantee it.”

The next D-day is Aug. 15, when Treasury owes $29 billion in interest but will already have missed $54 billion in scheduled payments if the debt ceiling hasn’t been extended.

“I believe Treasury will always make sure, before all other government spending, [it has] enough cash to pay the interest on the bonds. That has to be the highest priority,” Powell said. “If we default on interest payments, we can sink the whole boat.”

“If there is a strong view that the bond interest payment won’t be made, and congressional leaders say they are nowhere near passing an increase in the debt limit, then you would start to see the basic underpinnings of the financial system come undone,” said a senior strategist at one of Wall Street’s largest banks, who spoke on the condition of anonymity because of the political sensitivity of the issue.

Analysts and former government officials said they expect Treasury to hoard all the cash it can to avoid a default. Doing that would mean slashing all other government expenses by 44 percent, according to a Bipartisan Policy Center analysis.

There are various options for choosing who would get government payments — none of them good.

“With 30 million or more Social Security recipients, if you could protect them some way, you would do so, but that’s going to require some very godlike distinctions between those folks and people drawing veterans’ benefits and those drawing [federal employee] retirement benefits,” said Gerald Murphy, a 20-year veteran of the Treasury Department who served as fiscal assistant secretary during the last major showdown over the debt ceiling in 1995 and 1996. “You probably wouldn’t even be able to pay that entire population.”

Members of Congress have already introduced legislation to make military paychecks a priority if the debt ceiling is reached. Holding back either the modest salaries paid to the military or monthly payments to retirees would spur major hardship and public outrage.

The feds might decide to slow or stop payments to hospitals and doctors. California is already bracing for such a scenario by taking out a $5 billion line of credit. Defense contractors and other government vendors would be an obvious target for delayed payments. But they’re legally entitled to interest if they are paid late.

In an interview Sunday, Office of Management and Budget Director Jack Lew repeatedly refused to say whose payments would get priority in the event of a cash shortfall. “It’s unacceptable for the United States to be in a place whether it’s Social Security recipients, or a soldier or somebody who is just owed money by the government [who] can’t be paid because we have not done our job,” Lew told CNN.

Some experts doubt that it’s even possible for the government to prioritize payments in a logical way.

“To try and centrally stop payment or adopt a policy of paying 10 cents on the dollar, it’s virtually impossible,” Murphy said. “The Defense Department has [its] own disbursing offices. There is no one person who can push the button and turn it off.”

One major debt rating agency, Standard & Poor’s, warned last week that even a few missed vendor payments could lead to a downgrade of the U.S. credit rating. Some big money-market funds that can only hold the safest investments might be forced to sell U.S. bonds if they are no longer AAA.

But many such funds require a AAA rating on bonds from just one agency, not all three, or allow a AA rating. So, many analysts say, a single agency’s downgrade would likely cause only marginal disruption.

“The first rule of capital markets is that they discount the future. The apocalypse only happens when you don’t expect it,” said James G. Rickards, senior managing director for market intelligence at Omnis Inc. “The things you expect are discounted to some extent and therefore are non-apocalyptic.”

“This does not mean there will not be volatility and disruption — there will be,” Rickards added. “But the system will muddle through, and the markets will still be standing. As long as [bond payments] are made, markets don’t care if the cash flow shortage comes out of the checks to school lunches or veterans — harsh but true.”

Former officials said one possible scenario is that by design or because of a lack of control, Treasury might punt much of the politically unpalatable decisionmaking to the Federal Reserve Board. Then, the Fed would have to prioritize or simply refuse to do so.

A Fed spokeswoman had no comment on how the agency would deal with government accounts running dry.

“They would honor what came in until they couldn’t honor any more,” Murphy surmised. “Presumably, they’d kick back or put on hold anything else.”

Another wild card is the $470 billion in Treasury bonds and bills scheduled to mature in August. Typically, Treasury borrows more money to replace the maturing debt with little to no net impact on the debt ceiling.

However, in the turmoil that could surround a near-default, borrowing costs could increase sharply and require more scarce cash. It’s even possible, though unlikely, that uncertainty could lead to a lack of buyers for U.S. treasuries and produce an even greater cash shortfall.

On Friday, Treasury announced it had taken the last of its stopgap measures to avert reaching the debt ceiling: suspending the practice of buying U.S. government securities with roughly $23 billion in funds used to counter sharp charges in currency exchange rates. The money will be available for that purpose, it will just sit in cash.

Still, Treasury concedes it has not done everything possible to stave off a default or even a cash shortfall. For instance, the U.S. owns $11 billion in gold — $6.2 billion of it in Fort Knox — according to a Treasury report last month. But Geithner hasn’t ordered the sale of any of it and doesn’t plan to.

“This is not a viable option,” Geithner wrote in an April 4 letter to congressional leaders. “To attempt a ‘fire sale’ of financial assets in an effort to buy time for Congress to act would be damaging to financial markets and the economy and would undermine confidence in the United States. … Selling the nation’s gold, for example, would undercut confidence in the United States both here and abroad.”

Anything that the market regards as a true default could cripple the struggling U.S. economy for years to come, experts said.

A serious and extended debt ceiling breach could lead big U.S. bond investors such as China to demand higher interest rates, which would in turn mean higher borrowing rates for businesses and consumers.

That would inevitably lead to slower economic growth, fewer jobs, higher mortgage rates and perhaps a prolonged double-dip recession — or even a depression.

The long-term damage of even a slight increase in interest rates could be enormous. It could cause a 1 percent increase in interest rates that economists said could shave nearly 1 percent off economic growth and cost 800,000 jobs every year.

Obama warned of potential rate increases during his news conference Friday, characterizing them as tax increases for all Americans.

“This is not just some abstract issue,” he said.