The Treasury will stop paying some obligations in August if the debt ceiling isn't raised, but how is that any different from the "extraordinary measures" it's already taken?
The concept of default should be straightforward: either you pay what you owe or you don't. But in the case of a complex entity like the U.S. government, what constitutes default becomes a little bit more complicated. As the August deadline for the debt ceiling battle approaches, this question takes on greater importance. At what point will rating agencies consider the U.S. in default -- and what exactly does that mean?
The Basics of Default
Let's start with fundamentals. Imagine that you have no debt or credit. You purchase a car by taking on your first loan. A few months later, you lose your job and can no longer afford to pay. Based on the terms of your agreement, a failure to make a monthly payment within a specified period of time will put you in default. In most cases, the lender will repossesses your vehicle.
Now imagine that you have lots of different kinds of debt -- student loans, credit cards, a mortgage, a time share loan, and that car loan. If you continue making payments on the auto loan but stop paying your mortgage, then the situation changes. Your auto loan won't be in default, but eventually your mortgage will be.
When a Nation Defaults
Now let's translate this to sovereign debt. Like that person with lots of credit, the U.S. has lots of different obligations. To name just a few, it has to pay employees, contractors, Social Security recipients, and of course investors who hold its debt. So what does it mean for the U.S. to default on its debt? The analogy above holds: unless the U.S. misses an interest payment on that debt, it will not be considered in default.
That's according to a few of the rating agencies. U.S. debt analysts Steve Hess of Moody's and Nikola Swann of Standard and Poor's both hold this view. There's no partial or sort of default in their eyes. If the U.S. misses an interest payment on its debt, then it will be in default. If it continues to make those interest payments -- no matter what happens with the rest of its obligations -- it will not be in default.
Does Effective Default Matter?
Each analyst shrugged off the concept of effective default. Over the past few months, some commentators have suggested that if the U.S. cannot pay all of its obligations come August, then it will effectively be in default. Even if it continues to make interest payments, the nation will show an inability to live up to all of its obligations.
Neither analyst indicated that this concept of effective default played a role in their methodology. So long as the Treasury prioritizes interest payments to ensure that sovereign debt investors get paid, the U.S. will be considered a creditor in good standing. With that said, however, Moody's analyst Hess suggested that if the debt ceiling is not raised this summer, the U.S.'s Aaa-rating will be put on review for possible downgrade.