Is the U.S. Effectively in Default Already?

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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?

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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.

I also asked Hess about why the August deadline is more serious than the May deadline, after which time the Treasury was forced to take "extraordinary measures." Those measures consisted of halting payments or debt issuance regularly provided to other government entities -- not obligations to sectors outside the government. In August, however, the Treasury will be forced to stop paying obligations that extend beyond just internal distributions.

Think of it this way: if some parents had money troubles, then halting payments to their kids' college fund wouldn't be as big of a problem as if they stopped paying their mortgage. 

But Will Treasury Prioritize Interest Payments?

A bill introduced by Sen. Pat Toomey (R-PA) earlier this year would require the Treasury to prioritize interest payments above others to ensure that they get paid. A press release from Toomey says:

The federal government's tax revenue is projected to cover about 67 percent of all government expenditures, while interest on our debt amounts to only 6.5 percent of all projected expenditures. The administration will have more than enough income to honor the government's debt obligations without defaulting.

Neither rating analyst saw this legislation as very significant, however. Each assumes that the Obama administration will continue to prioritize debt anyway, because the Treasury understands the gravity of a default. Hess said that such laws do sometimes help to raise state and local government debt ratings, however.

What About Currency Devaluation?

Last week, Chinese rating agency Dagong Global Credit said that the U.S. "has already been defaulting," in its opinion. It based this assertion on its assessment of the value of the dollar, which it said has been declining. The principle here would be that the U.S. debt and its interest was worth less than anticipated, because it's denominated in U.S. dollars, which Dagong says have weakened against other currencies.

Neither Moody's nor S&P share the view of Dagong, however. In fact, the value of a currency does not come into play when the U.S. agencies provide a sovereign debt rating. Each analyst said that the rating is simply based on the country's ability to pay, no matter how much value a currency loses over the life of the debt. It's the job of the investor to worry about currency valuation.


So for now, it looks like even if a debt ceiling deal isn't reached by August, the U.S.'s AAA-rating will be safe. While that could change in the months that follow if a deal remains elusive, the Treasury will almost certainly make sure that an the U.S. does not miss an interest payment. Doing so would have disastrous consequences.

Image Credit: REUTERS/Jim Young

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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