Default hysteria has heated up as the federal government shutdown spills into its second week and October's debt deadline draws closer. The President, Treasury Secretary Jack Lew, and most Republicans agree that a debt default, not paying interest on federal debt, would be a calamity far worse than the Lehman crisis. PIMCO co-chief executive Mohamed El-Erian said as much earlier this month. But PIMCO’s other co-chief, Bill Gross, is buying treasuries. Why?

The answer is simple. There will be no default—on Treasuries, at least. But paying Treasuries after the X Date will mean less money for the rest of government, meaning a much weaker economy, which will further drive down interest rates lower and drive up the price of treasuries.

Reaching the debt ceiling, which we will do at least by the end of October, means no more new government borrowing until it is raised. But not borrowing does not mean defaulting on interest payments on government debt. Much like approaching your credit card limit has different consequences from missing a payment, hitting the debt ceiling is not synonymous with defaulting on debt. Households prioritize outlays as borrowing limits are reached, paying mortgages or rents and perhaps minimum credit card payments, while curtailing more discretionary spending such as eating out and going on vacation. The US treasury will have to prioritize too.

Hitting the debt ceiling means that government spending gets cut dramatically, by about 20 percent under current conditions. The CBO projects the federal government will spend $3,602 billion in fiscal year 2014, $560 billion of which will be financed by borrowing, and $237 billion of which will be spent on meeting interest obligations. Without new borrowing and while continuing as it is required to do (pay interest on its debt), the federal government will have $797 billion (20 percent of $3,602 billion) less available to spend on non-interest obligations. If mandatory spending remains unaffected, the cuts would force discretionary spending to drop by 48 percent.

Figure 1 demonstrates what percentage cuts in outlays would have been necessary in prior years in order to avoid default, given the exclusion of new borrowing and the requirement to pay interest on the debt.

Pre-crisis levels troughed at approximately 15 percent in FY2007, when revenues were high and borrowing low, then increased to 24 percent in FY2008 and spiked at 45.5 percent in FY2009, a sign of the stimulative fiscal policies enacted to counter the recession during that time. Though these levels have since declined – due to a decrease in debt issuance and interest rates since 2010 – during the last debt ceiling crisis, in 2011, the cost of avoiding default would have been twice as high as it is today, requiring spending cuts of approximately 42 percent. Perhaps this explains why an agreement, then, was reached fairly quickly. Regardless, during late July and early August of 2011, the S&P fell be 20 percent, and third quarter growth, which had been estimated at 3.3 percent in the June Wall Street Journal poll, turned out sharply weaker at 1.4 percent that year. Prices of treasury notes and bonds soared as interest rates collapsed. The yield on the treasury 10 year note fell by 80 basis points between July 28 and August 9 of that year, before an intensification of the Greek crisis pushed rates even lower in September.

Actual 2014 federal spending cuts of 20 percent, about 5 percent of GDP, would create enough fiscal drag to plunge the economy into a nasty recession that would spike unemployment, usher in a dangerous deflation, and start a vicious cycle of falling government revenue and spending. The fall in revenues could not be offset with deficit spending because the debt ceiling would be in place. Nor could the Fed provide relief since short term interest rates are already at zero and QE strategies largely exhausted.

In short, we’d have a real debt-ceiling-driven crisis with falling long term interest rates. Even worse than in 2011.

Congress has not yet grasped how awful the overnight 20 percent cut in 2014 spending implied by hitting the debt ceiling will be for the already-weak economy. The Sequester, enacted on March 1 of this year, was the equivalent of a 5 percent federal spending cut over a full year. Today’s debt ceiling-driven spending cuts would be four times as large. The leaky shutdown hasn’t produced much pain yet, but as we approach the much sharper cuts attached to averting default, as in 2011, stocks will drop and growth forecasts will be cut sharply.

The President and members of Congress who are predicting instant default-chaos by month end will, in the absence of the promised default, be seen as crying wolf just as they did prior to the onset of Sequester. Debt ceiling talks won’t progress until it dawns on President Obama and leaders in Congress that continuing on a path that cuts spending by 20 percent, and more in future years, will create a recession and a collapse in employment and inflation. That unwelcome outcome, or hopefully just its prospect, will be the driving force in Congress raising the debt ceiling.

In the meantime, the debt ceiling scare needs to be managed while Congress stumbles toward an agreement on spending and borrowing. The treasury needs to promptly prioritize outlays, with interest payments on debt at the top of the list. Additionally, the President needs to make a concession on Obamacare implementation and/or entitlement reform. Then House Republicans could bring a new continuing resolution to the House floor. Such a hard fought compromise needs to keep away similar scares for at least a year.

Failing this, we’re heading for a nasty recession. It won’t come right at the X Date, like the default promised by “drop dead” debt ceiling doomsters, but it will come soon enough. And that outcome means everyone loses – except buyers of treasuries.

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