Shutdown just stepping stone
The current US federal government shutdown - which is more of a slowdown - has merely set the stage for an even more nerve-racking deadline on October 17 when the US will cross their debt ceiling. At most the government could get by for another couple of weeks with $30bn cash on hand, but without a deal the US will in effect be in default in a couple of weeks.
During the negotiations, Republicans will tie raising the ceiling to delaying, defunding, and scaling back Obamacare (important parts of which have started being implemented this month). Also they will load a debt limit bill with dozens of conservative priorities. The fine line between negotiating and extorting has become very blurred indeed (but this is not something the GOP is only to blame for).
Some disturbing precedents
During the debt ceiling fight in 2011 consumer confidence took a serious hit, stock markets cratered, the US credit rating was downgraded, and hiring slowed.
If we go a couple of decades further back, we find that the US defaulted in 1979. It was a technical default due to some clumsy mistakes and it only concerned $122m, but that translated into a loss of $12bn and according to some it has permanently raised the costs of government borrowing.
In 1957, the Air Force stopped paying its bills due to the US hitting the debt ceiling. This amounted to $8bn less spent ; the equivalent of 1.7% of GDP. Researchers claim this default was one of the main reasons for the recession of 1957/1958.
Worldwide chaos
If politicians can't reach a deal on time, the US can only spend as much as incoming revenues. That means a 20-40% reduction in government spending. That would tip America into recession even before accounting for the resulting financial chaos. Every week the Treasury rolls over $100bn in debt. If investors decide they just want their money back, this would result in interest rates rises that could nip the still vulnerable recovery in the bud.
We still think that even the Tea Party is adverse to being blamed for making the US a defaulter and according to scholars the law offers Obama a way out by just plainly ignoring the debt ceiling if Congress doesn't come to an agreement.
A default isn't inevitable, but the current unpredictable behavior of - in the words of one Democratic Representative - this Congress of Chaos will probably unnerve markets the coming weeks. James MacKintosh wrote for the Financial Times: "Investors usually hope for the best from Washington until the last minute. Then they panic." Politico spoke of a "touch-the-stove moment" when writing about the GOP's handling of the shutdown. The stove will be even hotter within two weeks and it remains to be seen if politicians are prepared to burn their hands even further.
If the US defaults, financial markets worldwide will go into cardiac arrest, because markets are not set up to trade or finance defaulted Treasuries. The Atlantic calls "not raising the debt ceiling a crisis, if we're lucky, a historic calamity if we're not." Let's hope Washington will get to its senses and reach a deal before pandemonium starts.