What If Uncle Sam Defaults?

First, foreign investors get edgy. Fearing they won't collect on billions in overdue U.S. Treasury securities, they start unloading their holdings. The dollar swoons. Wall Street holds out a little longer, but soon the selling pressure erupts. Falling bond prices push up interest rates, perhaps a quarter of a point. Then lawyers fly into action, arguing that pension and trust fund rules require funds to dump hundreds of billions in bonds.

A scenario for The Great Panic of '95? It could come close--if Washington's bitter budget battle forces the Treasury to default on its debt for the first time ever. Not since Alexander Hamilton persuaded the Constitutional Convention to assume the states' Revolutionary War debts in 1787 has the U.S. missed a payment on its obligations. Now, Washington is skating ever nearer.

On Nov. 1, with the debt pressing within $14 billion of the $4.9 trillion debt ceiling, Treasury said it may have to delay an auction of more than $100 billion in notes and bonds scheduled for Nov. 7-9. At a meeting the same day, President Clinton failed to reach a compromise with GOP leaders to temporarily increase the debt limit. Vows House Speaker Newt Gingrich (R-Ga.): Congress won't grant a long-term increase in the debt ceiling until the President capitulates to GOP tax and spending cuts.

HOBSON'S CHOICE. Given the grave consequences of a default, investors are betting calmer heads eventually will prevail. Traders appear confident that Washington will head off default and come up with a budget-balancing plan--which is one reason long-term interest rates have been falling, despite Gingrich's threats. The dollar also has risen lately, reflecting confidence overseas. "It's like The Perils of Pauline," says economist Bruce Steinberg of Merrill Lynch & Co. "The government gets tied to the tracks once more but somehow never gets sliced by the train."

But what would happen if the unthinkable comes to pass and the U.S. government actually does default on its obligations? Treasury expects to exhaust its borrowing capacity and cash reserves during the week of Nov. 6--and faces $100 billion in interest and principal payments by Nov. 16. At that point, Clinton could face a choice between the illegal and the unthinkable. In theory, he could tap the $1.2 trillion the government has parked in Medicare, highway, and other trust funds. But after President Reagan dipped into the Social Security trust fund during a similar row in 1985, Congress made it illegal to tap the major funds for anything but benefits.

WORSE NEWS. Even so, Clinton probably would opt for a legal donnybrook over the alternative: letting millions of bondholders lose principal and interest. If that happened, foreign investors--who own 25% of privately held Treasuries--wouldn't wait for even a quick political settlement. "We may see a markdown of U.S. assets if there's tremendous disruption of the financing schedule," says George Magnus, chief international economist at Union Bank of Switzerland in London. U.S. bond traders would follow, and the contagion would soon spread to stocks.

The long-term effects would cost even more. Treasuries would no longer be the world's safest securities. Investors would demand a "risk premium"--and every 0.1 percentage point added to rates eventually increases Washington's annual interest tab by $5 billion. "You could pay for lots of education programs with the extra interest," says Clinton economic adviser Joseph E. Stiglitz. The same 0.1-point rate hike would knock $8 billion off the value of bonds held by pensions and add $800 million in annual interest costs for homeowners with adjustable-rate mortgages.

Republican hard-liners insist that such a disruption is a small price to pay for the benefits of a balanced budget. But there's little evidence that default is necessary to get to that end. After all, Clinton is willing to negotiate. "Gingrich doesn't want to see Clinton on national TV saying: `I'm raiding the Social Security trust fund because the Republicans forced me to do it,"' says L. Douglas Lee of HSBC Washington Analysis, an investor advisory firm. The risk of triggering the next step--default--should be enough to persuade Washington to shelve The Great Panic scenario for good.

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