The U.S. Avoids Default in 11th Hour

What would happen if the U.S. defaults? That was the $14 trillion question as the nation approached its debt ceiling.

by Jennie Wood

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In early August, Congress and President Obama made a last-minute deal to avoid a default on the U.S. debt, but as the deadline to raise the debt ceiling approached, many people wondered what would happen if the government failed to reach an agreement. Some believed a default would send the global economy spiraling, while others said the consequences would be insignificant.

If the U.S. government didn't make a deal to raise the debt ceiling by August 2nd, credit rating agencies, such as Moody's and Standard & Poor's, warned that they would downgrade the country's current AAA-rating. Treasury bonds and other asset classes would have felt the impact of a downgrade. Around $130 billion in municipal bonds would have been downgraded and all other bonds would have come under review. The financial sector, which had previously assumed that the government could bail out major banks if they ran into trouble, would not have that safety net if the government was broke. A default would also have put a strain on the U.S. and its creditors. In Treasury bonds, U.S. dollars account for a large percentage of global bank reserves. For example, China holds about $1 trillion in U.S. Treasury bonds. The value of China's holdings would have decreased if the U.S. defaulted.

The biggest issue with the default was the uncertainty. No one knew for sure just how much it would affect the already shaky U.S. economy or the global market, mainly because the U.S. hadn't been in the situation before. Some economists argue that the U.S. has defaulted twice on its debt: in 1790, when the federal government restructured bonds issued to fund the Revolutionary War; and in 1933, when Congress passed a bill making it illegal for creditors to demand payment in physical gold. However, even though both incidents were technically defaults, the creditors involved were paid. Therefore neither situation could shed much light on the possible U.S. default in August 2011.

Late in the evening of July 31, President Obama and Congressional leaders reached an agreement that would raise the debt ceiling by $2.4 trillion in two stages. They also agreed that $2.4 trillion in spending cuts would be made over the next decade and $900 billion in cuts would be made immediately. The House approved the plan on August 1st. The Senate approved it on the following day. A default was narrowly avoided. A bipartisan Congressional supercommittee was appointed and given until Thanksgiving to find $1.2 trillion in deficit reductions.

In November 2011, the Congressional supercommittee failed to agree on what programs to cut after more than 10 weeks of negotiations. Therefore, $1.2 trillion will automatically be cut from military spending, education, transportation, and Medicare. The committee's failure also set the stage for Congress to spend the next year battling over which programs would receive deeper cuts.

Throughout 2011, states also struggled with the stalled economy. Minnesota Democrats and Republicans failed to agree on a solution for the state's budget problems, and the government shut down over the summer. State employees were sent home without pay. Parks, historical sites, the Minnesota Zoo, and all major rest areas along highways were among the many state services closed. In November, Alabama's most populous county, Jefferson, filed the largest municipal bankruptcy in U.S. history. Jefferson County was over $4 billion in debt.

By December, the federal unemployment rate decreased to 8.6%, its lowest level in two and a half years. While the debt crisis in Europe grew worse in the last days of 2011, the U.S. economy appeared to be on the mend.

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