04/14/2011 03:31 pm ET | Updated Jun 14, 2011

Threats of Default Aren't Free

Can you imagine the howls that would come out of the Republican side of the aisle if the Democratic leadership in the House and the Senate threatened not to increase the debt limit until the Republicans committed in advance to a roll back of the Bush tax cuts for the wealthiest one percent of Americans? Glenn Beck might even stay on Fox News for another season just to ride that huge wave of outrage.

Yet, like the madman holding a gun to his own head and screaming: "Stop or I'll shoot", House Speaker John Boehner and Minority Leader Mitch McConnell recently indicated that there would be no increase of the debt ceiling without a commitment to substantial spending cuts from the Democratic side of the aisle, thereby threatening to put the Federal Government in default on its debt obligations in the very near future.

So, let's, for a moment, take Speaker Boehner and Leader McConnell at their word and assume that they're prepared to allow the government to default on its debt. What then?

First, since US Treasuries are a primary holding of virtually every major bank, every major insurance company, every major pension fund, and most money market funds in the world, a default by the federal government would surely plunge the entire global financial system back into crisis, making the fallout from the bankruptcy of Lehman Brothers in September 2008 look like a walk in the park on a sunny day.

And since the federal debt is held in substantial part by Americans, a default would destroy the retirement accounts and savings of hundreds of millions of people throughout the country. The loss of wealth American households would experience would make the bursting of the housing bubble feel like a pin prick.

While some Republicans have indulged the fantasy that we could stay under the debt ceiling and avoid a default by giving priority to interest payments over everything else in the federal budget, such an approach would require we immediately eliminate the $1.5 trillion difference between the government's current revenues and its current expenditures.

That sounds like a pretty good outcome until you realize just what would have to happen -- and happen quickly.

Let's suppose we eliminated that $1.5 trillion solely by reducing government spending, as the Republicans would have it. To close that budget gap without any borrowing or new taxes, every major category of federal spending would have to be reduced by 40 percent. Not over the next few years, but right now, before the end of June.

And that doesn't mean just cutting foreign aid or the salaries of federal employees which represent relatively small portions of the overall budget. You'd have to go where the real money is: Defense, Medicare, Medicaid and Social Security.

So, for example, take this year's $700 billion budget for the the Defense Department and the wars in Iraq and Afghanistan: $280 billion would have to be immediately cut. Or take the $800 billion budgeted this year for Medicare and Medicaid: $320 billion of it would have to be immediately cut. And on top of all of that, cut 40 percent out of every Social Security check starting in July. You get the idea.

The number of veterans, soldiers, seniors, students, teachers, doctors and nurses marching on Washington to protest those cuts would make the Tea Party look like, well, a tea party.

So, the threat that Speaker Boehner and Leader McConnell would put our nation into default simply isn't credible, because it would lead to the end of the Republican Party as we know it.

The budget constraints that the Congress is now confronting are real. Resolving them requires leadership on both sides. It also requires an open discussion about how to balance tax increases and spending cuts so as to put the country back on a fiscally sustainable path without undermining the key commitments we have made to another that make this country the envy of all others in the world.

Defaulting on the existing debt, however, would only make our budget problems worse. God forbid the markets start to fear that the Republicans are serious with their default threats. That would lead to a permanent increase in the interest rates the government has to pay to borrow money. To cover that increase in interest expense, even deeper cuts in other parts of the budget or even higher tax increases would be required. Threats of default aren't free in the credit markets: if the Republicans succeed in spooking the bond market, it will make an already difficult set of choices even harder.

So, it's time to stop the reckless posturing, increase the debt ceiling and get down to the real business of putting the country on a sustainable fiscal path. Playing a game of chicken with the full, faith, and credit of the United States is simply irresponsible.

Jim Millstein was, until February 2011, Chief Restructuring Officer at the US Department of the Treasury. He was previously Head of Restructuring and Managing Director at Lazard.