What happens if we donâ€™t raise the debt ceiling but continue to pay interest on our bonds? This is an option known as â€œprioritization.â€ The Bipartisan Policy Center released a reportattempting to think through how this would work in practice, as it has never been attempted before. The raw numbers are chilling: In August, the federal government would have to cut expenditures by about $134 billion, or 10 percent of the monthâ€™s GDP. If it chose, for instance, to fund Medicare, Medicaid, Social Security, supplies for the troops and interest on our bonds, it would have to stop funding every other part of the federal government. The drop in demand, when coupled with the turmoil in the markets and the general financial uncertainty, would undoubtedly throw the economy back into a recession. Also keep in mind that we have to roll over $500 billion in debt that month, and if there was uncertainty about how we were going to pay our bills, it is not clear we could find buyers for our debt at anything less than an exorbitant rate. In this way, â€œprioritizationâ€ could actually increase the deficit.
What happens if we stop paying the interest on our debt? This is too scary to consider for any serious length of time. Treasury securities sit at the base of the global financial system. They are considered so safe that the interest rate on Treasuries is called the â€œriskless rate of return,â€ as the market assumes there is no chance of default under any circumstances. Almost all other types of debt â€” mortgages, credit card, auto loans, business loans, hospital bonds, etc. â€” are yoked to Treasuries. Almost all major financial players hold substantial portfolios of Treasuries or Treasury-related debt in order to buffer themselves against financial shocks. Consider that the 2007 financial crisis was caused by the market realizing it had to reassess the risk of bonds based on subprime mortgages. If the market has to reassess the risk of Treasuries, the resulting financial crisis will be beyond anything weâ€™ve ever seen in this country.
Do we need a debt ceiling? Strictly speaking, no. The debt ceiling is unique to America. In other countries, when the legislature passes a law, the Treasury is given automatic authority to carry it out. A number of former Treasury Secretaries have said it should be abolished, including Larry Summers, who said, â€œI think that given that Congress has to approve all spending and all tax changes, there is not much logic to the debt ceiling.â€