What Happens if a U.S. Debt Default Occurs?

Not to go all Armageddon on you, but what if the "unthinkable" happens within the next couple of weeks, and the U.S. actually defaults on its debt by not raising the credit ceiling?

Some analysts, including the U.S. Department of the Treasury, are saying it would be as bad – or worse -- than the financial collapse of 2008. Of course, most of us have become cynical enough of the political process to discount such fear-mongering.

But, still. What if?

Should we be taking some prudent steps now to prepare our investment portfolios, our businesses and our lifestyles, just in case? Let's consider the doomsday scenario that is being offered by the Henny Pennys of the world.

(SFX: Tense music. B&W VIDEO: Smoking rubble of destruction. Voiceover by the guy that does the "In a world..." movie trailers.)

The U.S. Department of the Treasury says that a default would be "unprecedented and has the potential to be catastrophic." Credit markets could freeze. The value of the dollar could plummet, and U.S. interest rates could skyrocket.

The Treasury Department has analyzed the impact on the financial markets the last time we walked out onto the edge of the cliff in 2011. The report explores consumer and small business confidence, stock price volatility, credit risk and mortgage spreads. 

Just the possibility of a default "could roil financial markets and damage the economy, thereby harming American businesses and households," the report says. The Treasury analysis offers these potential implications of a U.S. default:

  • Market pains. The debt ceiling impasse in 2011 contributed to long-lasting scars on financial markets, which persisted for many months.
  • Sharp declines in household wealth. Household consumption spending accounts for about 70% of GDP. From the second to the third quarter of 2011, household consumption fell $2.4 trillion.
  • Increases in the cost of financing for businesses and households. The 30-year conventional fixed-rate mortgage spread over Treasury yields jumped by as much as 70 basis points late in the summer of 2011. In the summer of 2011, the BBB credit spread jumped 56 basis points. 
  • A fall in private-sector confidence. Consumer and business confidence were falling in 2011, and as the debate about the debt limit progressed, business and household confidence fell to levels that are typically only seen during recessions. It took months before confidence recovered, even though, ultimately, there was no default. 
  • In the event of a default, the U.S. economy could be plunged into a recession worse than any seen since the Great Depression. The U.S. dollar and Treasury securities are at the center of the international finance system. In the catastrophic event that a debt limit impasse were to lead to a default on Treasury securities, financial markets could be shaken to their core as was seen in late 2008, which resulted in a recession worse than any seen since the Great Depression.

"As we saw two years ago, prolonged uncertainty over whether our nation will pay its bills in full and on time hurts our economy," Treasury Secretary Jacob J. Lew said in a statement issued with the report. "Postponing a debt ceiling increase to the very last minute is exactly what our economy does not need – a self-inflicted wound harming families and businesses. Our nation has worked hard to recover from the 2008 financial crisis, and Congress must act now to lift the debt ceiling before that recovery is put in jeopardy."

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