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.