Although I think it is a very low probability, here is how things might play out if our worst nightmare comes true and the debt ceiling is not extended for a reasonable period of time. I think what you will see is a very sharp contraction in the economy which will lead to a big drop in the stock market. Guessing what happens to interest rates and the dollar is slightly more tricky. I am pretty sure the Treasury Department will give interest rate payments the highest priority so we are not going to default on the debt. I believe you may see a little bit rise in the interest rates on the very short end but long term rates may drop significantly as you are going to go into a deflationary environment. Figuring out the dollar is the most tricky as the declining economy is going to put pressure on the dollar but deflation also supports the currency as it increases the buying power of the currency. What I have observed is that whenever debt ceiling talks break down the dollar falls, so it is reasonable to conclude that at least the short term reaction in the dollar will be negative.
To see why the economy will tank, you just have to go to the basic equation of GDP
GDP = C + I + G + E
C = Private Consumption
I = Investment
G = Government Expenditure
E = Net(Exports – Imports)
As you can see Government expenditure is a direct component of GDP. Currently the US government finances around $1 trillion of government expenditures which is around 7% of current GDP(current GDP is around 14.5 trillion). If you abruptly stop that, you are going to see at least an annualized 7% drop in GDP, on top of that you will have negative multipliers on the other components so most likely you will have a larger than 7% drop. I am going to be optimistic and guess that the drop in GDP will be at an annualized rate of 8%. These are very rough calculations and are not based on some complicated model but I think they are reasonable qualitatively.
Just to put that in perspective the latest estimate of peak to trough drop in GDP from the 2008-2009 recession was 5.1% over 6 quarter, so it was a 3% annualized drop. We lost 7 million jobs in that recession. It is easy to conclude that an 8% annualized drop is going to be really nasty.
I understand that this $1 trillion deficit is not sustainable, but it is totally irresponsible to reduce that much spending in an abrupt manner. We need to tackle the deficit over the long run in a planned manner where we bring down govt deficits slowly while other components of GDP pick up the slack.
I think some of the Tea Party candidates like Michele Bachman who downplay the seriousness of not extending the debt limit are completley out of touch with reality.