Default is the political flavor of the week. It is being used in connection with that other inside the beltway buzzword, debt limit. But what does this really mean and how does it work?

For better or for worse the Federal Government imposed a legislative control on how much money it can borrow. The Congress sets a limit on the amount of debt that the Feds can incur. The rule is usually a simple goal for the government and not a hard and fast limit since the Congress routinely raises the limit whenever the limit is reached. But not this time. Once more the Republicans in the Congress want to subject raising the limit to defined cuts in Federal spending. The connection is not obtuse since Federal borrowing is directly related to Federal spending. At present some 20-25% of Federal spending is paid through borrowing.  

The last time the debt limit was raised about a year ago it was done with the adoption of the sequester that is an across the board reduction in Federal spending.   All parts of the Federal operation saw cuts in their spending.  This was the demand of the Republicans and since then the Democrats have been stewing about seeing their favorite programs cut. 

But what does this mean for the default?  The theory here is that if the Feds cannot borrow more they will not have the funds required to service current debt, i.e. no interest paid or debt retired.  And if the current debt is not serviced the Feds will lose their ability to borrow.  However, the theory is flawed because there is no reason or law that demands debt servicing be done out of borrowed funds.  The Feds can use current income, i.e. tax revenues, to service the debt and maintain the integrity of its borrowing. 

Of course using current revenue to service the debt means that some parts of Federal spending will be cut since the Feds currently pay 75-80% of expenditures from current revenues and the rest from borrowed funds.  In essence lack of additional borrowing will act like the absence of a continuing resolution to fund current expenditures, i.e. the Feds will have to prioritize expenditures to make sure they are paid from current revenue and not borrowed funds.  In other words the Feds will be limited to a pay as you go operation and will have to cut 20-25% of its programs.

To sum it up failure to raise the debt limit will mean reduction in Federal spending, but not mean a default on Fed debt.  It will act very much like the failure to adopt a continuing resolution but will not cause a default.