The story doing the rounds is that the US may be forced to default on its sovereign debt. This is simply nonsense, and serves no one's interests because it clouds the real issues surrounding the US budget deficit, which genuinely is becoming problematic.
First, the US's existing debt obligations. Contrary to these doomsday scenarios, the US is not going to default on its sovereign debt, because there is absolutely no reason to do so. The debt ceiling is just that, a ceiling, and it does not prevent roll-over when bonds expire at maturation. The US government will just roll over the debt by issuing new bonds to replace the old, as it usually does and will continue to do: there is zero chance that the US will default on its repayments of principal. What the US administration will be precluded from doing without Congress's agreement is issuing new bonds to fund new deficits on the current account.
There is of course the issue of interest on the debt. Will the administration choose to go into temporary default on interest payments? That is highly improbable, because it has plenty of revenue to meet its debt servicing obligations: interest expenses represent under 10% of federal tax revenues annually (excluding payments into the Social Security Trust Fund for accrued future social security obligations) of which about a half is held by non-US lenders, and it is pointless defaulting on interest when there is no need to do so, because it would very significantly drive up borrowing costs when existing debt is rolled over, possibly to unsustainable levels. Anyway, arguably the US constitution requires the administration to give priority to debt servicing, as section 4 of the 14th Amendment provides that:
"The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned"This was originally designed to boost market confidence following the US government's repudiation of the debts of the Confederate government after the end of the civil war, but still stands as a general guarantee of government borrowing. Having said that, there is not too much distinction between a contractual obligation under bond warrants to repay at the due date fixed for maturation and meet interest obligations, and a constitutional obligation to really, really repay at the due date fixed for maturation and meet interest obligations. The amendment is window dressing, but window dressing with a purpose.
So whilst the US Treasury have said they will reduce allocations pro rata to all federal departments beginning late next week, this will almost certainly not include the Treasury's own interest obligations on its debt.
So the dangers lie elsewhere. These are two fold. First, the accumulating debt is going to become unsustainable: it is currently $14.46tn, which is around 96% of GDP, and going up at an astonishing rate of over $1tn a year. The US administration simply has got to get the budget under control. It could do this relatively easily by raising tax rates, but the republicans, who control the House, are blocking this. On the other hand, the democrats, who control the Senate, are blocking major cuts in federal expenditure. So there is stalemate.
Secondly, the problem if Congress does not raise the debt ceiling is that there will have to be very significant and immediate cuts in federal expenditure, probably over 20% (I have not seen the US Treasury put a figure on it) which is going to cause major disruption to the US economy. A period of (albeit probably temporary) deflation is not going to help a world barely coming out of recession. It is going to be particularly bad news if it pushes more US financial institutions into distress and insolvency. This also seems to be an unknown. The only way to handle the budget deficit is on a planned basis, not by a single big hit taking place overnight between Tuesday evening and Wednesday morning.
So if a deal can't be reached, the problem is not default on US sovereign debt, but default on commercial debt in the US brought on by deflation, and its domino effect on the world financial system.
The smart money of course is on the House and the Senate doing a deal some time next week.