Trea­sury Sec­re­tary Tim­othy Gei­thner says Con­gress has until August 2nd to approve an increase in the fed­eral debt limit — enabling the Trea­sury to borrow more money — or the U.S. gov­ern­ment will not be able to meet all of its finan­cial oblig­a­tions. Con­gres­sional Repub­li­cans are demanding deep cuts to reduce the fed­eral budget deficit in return for approving a debt-​​ceiling increase; Democ­rats prefer a com­bi­na­tion of budget cuts and increased rev­enues in the form of tar­geted tax hikes. Nego­ti­a­tions broke down last week, and Pres­i­dent Obama has now stepped in to try to sal­vage a deal. Here, North­eastern finance and eco­nomics instructor Richard Goettle dis­cusses what could happen to the finan­cial mar­kets and economy as a whole if Con­gress and the White House fail to find common ground.

The mar­kets often antic­i­pate bad news and factor it into prices ahead of events. How do you see that playing out in this case? How badly could the mar­kets be hurt by the impending threat of default?

To a cer­tain extent we are in uncharted waters here. We had two gov­ern­ment shut­downs in late 1995 and early 1996 arising for much the same rea­sons — a Demo­c­ratic pres­i­dent at log­ger­heads with a Repub­lican Con­gress. Finan­cial mar­kets became more volatile but did not expe­ri­ence dra­matic declines. Back then, how­ever, the most recent reces­sion was in the dis­tant past and the economy was in the ear­liest stages of the dot​.com expan­sion. Today there is more pes­simism and doomsday rhetoric because we are in the midst of an on-​​going global debt crisis and the world’s economies appear extremely fragile.

The degree to which mar­kets take a big hit will depend on how tem­po­rary or per­ma­nent the shut­down appears to be, if indeed it occurs. If mar­kets believe it will be short-​​lived, then it will not result in a pre­cip­i­tous shock. If, on the other hand, the per­cep­tion is one of a pro­longed shut­down increasing the like­li­hood of a true default, then mar­kets cer­tainly will reflect this.

If August 2 arrives without Con­gress approving an increase in the debt ceiling, what are the options for the Trea­sury Depart­ment, in terms of what bills and debts get paid?

Failure to approve the increase in the debt ceiling will not cause an imme­diate default on U.S. debt oblig­a­tions. On a monthly basis, the United States spends around $325 bil­lion and takes in about $208 bil­lion. Monthly interest on the national debt is about $25 bil­lion. So we could cover prin­cipal and interest on U.S. debt oblig­a­tions with cur­rent tax receipts and not default. This would force spending reduc­tions or tax increases totaling roughly $120 bil­lion a month to com­pen­sate for any spending gap.

In the 1995 and 1996 shut­downs, the Trea­sury and the Office of Man­age­ment and Budget devel­oped spending pri­or­i­ties for essen­tial ser­vices — debt ser­vicing, national defense and secu­rity, ben­efit pay­ments and the pro­tec­tion of health, life and property.

To the extent it would occur today, there is no ques­tion that a shut­down would have serious ripple effects throughout the economy. Cur­rently, public dis­cus­sion cen­ters on vague, worst-​​case sce­narios; the devil would be in the details of what the Trea­sury actu­ally funds in the event of a shut­down. It will have to fund debt oblig­a­tions to avoid default and also ser­vices deemed essen­tial, how­ever those are defined. But numerous gov­ern­ment ser­vices would be cur­tailed, delayed or elim­i­nated for the duration.

If we should go into default, some are pre­dicting an eco­nomic upheaval much worse than what just occurred in 2008, closer in impact to the Great Depres­sion. Could you talk about the most likely short– and long-​​term impacts?

Assuming that the debt ceiling is not raised, the like­li­hood of default increases to the extent that ongoing tax rev­enues cannot sup­port our debt oblig­a­tions and the lim­ited essen­tial ser­vices still being pro­vided. But I cannot imagine a pro­longed shut­down once politi­cians actu­ally see what elim­i­nating $120 bil­lion per month actu­ally means in terms of ser­vices. Brinks­man­ship will have a huge polit­ical penalty for those who choose to pro­long the eco­nomic discomfort.

But for the longer term, the U.S. debt crisis is very real. The U.S. and many of the world’s economies are on unsus­tain­able paths. The world needs to deleverage, which requires sac­ri­fices by all and a will­ing­ness to incur them. If the debt ceiling and debt crisis issues are not addressed in respon­sible ways, this will only increase the desta­bi­lizing influ­ences now at play in world finan­cial mar­kets, both for the near and longer term.

Debt crises take a very long time to unwind, but nei­ther the Great Reces­sion nor the Great Depres­sion need be repeated if more thoughtful and rea­soned heads were to pre­vail. If not, then it’s anybody’s guess.