If America Defaults, It’s Gonna Hurt

Written by Noah Kristula-Green on Thursday May 19, 2011

How painful would the cuts associated with default be? Well, they might be large enough to cause an economic downturn.

In an earlier blog post today, I noted that despite conservative attempts to hide the fact, there isn’t enough tax revenue to pay for all the spending that would be needed in the event of a default, and that painful cuts will be necessary.

Not only will the cuts be painful, but if they are prolonged they could also cause another economic downturn.

Economist Chad Stone of the Center on Budget and Policy Priorities explained to FrumForum that there is $2.2 trillion in revenue to be collected and more than $3 trillion in expenditures. If you are forced to make cuts to remove the difference, you are looking to cut around $1 trillion, or 10% of GDP at an annual rate, over the course of a year.

To put that in context, even the austerity measures implemented by the UK and other governments don’t come anywhere near that figure:

"There have been many instances where governments have reduced their budget deficits by 1.5% of GDP and that almost always lead to a serious weakening of economic growth in the short run.” According to Stone. So if the cutting would only occur for half a year, then at the end of six months cuts would be the on the order of 5% of GDP at an annual rate.  To achieve a UK style cut near 1.5% of GDP, there would only need to be cuts for a couple of months.

Some conservatives believe that as long as the debt continues to be repaid, the fact that significant cuts will be occurring to the military budget and the nation’s entitlement programs will be brushed off. This is the logic that informs Senator Toomey and Representative McClintock introducing legislation to prioritize paying off the debt. (Legislation which is unlikely to be adopted by the Congress.)

Stone is not convinced about the economic arguments:

“No matter which [default] you decide, the ones that you spare temporarily are not going to feel permanently spared. Its just as disruptive. It’s going to have the same impact on any person who hold the debt. They’ll say ‘wait a minute, if you’ve chosen not to pay those obligations, how can I be sure that next time you’ll honor the obligation to pay interest.?’”

Some conservatives may argue that achieving dramatic, sudden, and painful cuts is not only necessary but also desirable. This “growth with austerity” often informs many debates as a way of assuring skeptics they are not arguing the economy should take another nosedive. The arguments surrounding “growth with austerity” will need to be the subject of a future blog post.

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UPDATE: Chad Stone clarifies over email about the size of the UK cuts:

1.5 percent of GDP in a single year figure that I gave was the figure austerity studies have typically used as the threshold for defining incidents of major sharp fiscal consolidations (some have been larger and many have been longer) and was not meant to be an authoritative measure of the size of the UK measures (some of which have already taken effect and some of which have not) see e.g.

“Mr. Osborne unveiled proposed cuts equivalent to $130-billion (U.S.) through 2015. The deficit is forecast to fall from 10.1 per cent of GDP this year to 2.1 per cent by the 2014-15 fiscal year”.

That $130 billion would be 5-6 percent of annual UK GDP but spread over a few years.