As debt ceiling negotiations continue in Washington and the day approaches when the US government could be forced to stop paying some bills, all parties have warned that such a default would have catastrophic consequences.
But it may not take a default to hurt the US economy.
Even if an agreement is reached before the last minute, the prolonged uncertainty could drive up borrowing costs and further destabilize already unstable financial markets. This could lead to a fall in investment and business hiring when the US economy is already at heightened risk of a recession, and hamper funding for public works projects.
More broadly, the stalemate could weaken long-term confidence in the stability of the US financial system, with lasting repercussions.
At the moment, investors are showing little sign of concern. Though markets fell on Friday after Republican leaders in Congress declared a “pause” in negotiations, the declines were moderate, suggesting traders are betting the parties will eventually come to an agreement — like them have always done it before.
But investor sentiment could change quickly as the so-called X-date approaches, when the Treasury can no longer continue paying the government’s bills. Treasury Secretary Janet L. Yellen said the date could arrive as early as June 1. One thing is already happening: fearing the federal government will default on soon-to-be-due Treasury bonds, investors have begun demanding higher interest rates as compensation for greater risk.
If investors lose faith that leadership in Washington will resolve the standoff, they could panic, said Robert Almeida, global investment strategist at MFS Investment Management.
“Now that the stimulus is fading and growth is slowing, you’re starting to see all these little mini fires,” Mr Almeida said. “It makes the already difficult situation even more stressful. When the herd moves, it tends to move very quickly and violently.”
This happened during a 2011 debt ceiling stalemate. Analysis after that near-bankruptcy showed that the stock market crash wiped out $2.4 trillion in household wealth that took time to rebuild and taxpayers billions in higher ones Interest payments cost. Today, credit is more expensive, the banking sector has already been shaken, and economic recovery is fading rather than coming.
“2011 was a very different situation — we were in recovery mode from the global financial crisis,” said Randall S. Kroszner, an economist at the University of Chicago and a former Federal Reserve official. “In the current situation, where the banking system is very fragile, you take a higher risk. They pile fragility upon fragility.”
Mounting tension could cause problems across multiple channels.
Rising interest rates on federal bonds will affect borrowing rates for car loans, mortgages and credit cards. That’s hurting consumers, who have begun piling on more debt — and taking longer to pay it off — as inflation has raised the cost of living. Increasingly urgent headlines could prompt consumers to scale back their purchases, which fuel about 70 percent of the economy.
Although consumer sentiment is deteriorating, this could be due to a number of factors, including the recent bankruptcy of three regional banks. And so far it doesn’t appear to be affecting spending, said Nancy Vanden Houten, senior economist at Oxford Economics.
“I think that could all change,” said Ms. Vanden Houten, “if we get too close to the X date and there’s real fear of missing payments on things like social security or interest on the debt.”
Suddenly higher interest rates would pose an even greater problem for heavily indebted companies. If they have to roll over loans that are due soon, it could thwart their earnings forecasts at 7 percent instead of 4 percent and lead to a stock-selling rush. A general fall in share prices would further erode consumer confidence.
Even if markets remain calm, higher borrowing costs are straining public resources. An analysis by the Government Accountability Office estimated that the 2011 debt ceiling standoff increased Treasury Department borrowing costs by $1.3 billion in fiscal 2011 alone. At that time, the national debt was about 95 percent of the country’s gross domestic product. Now it’s 120 percent, which means debt servicing could become significantly more expensive.
“It will ultimately crowd out resources that can be spent on other high-priority government investments,” said Rachel Snyderman, senior associate director of the Bipartisan Policy Center, a Washington think tank. “There we see the costs of risky action.”
The disruption to the smooth functioning of federal institutions has already caused headaches for state and local governments. Many are issuing bonds through a US Treasury mechanism known as the “slugs window,” which closed on May 2 and will not reopen until the debt ceiling is raised. Public bodies that often raise money this way are now waiting, which could hold back large infrastructure projects if the process drags on.
There are also more subtle effects that may outlast the current confrontation. The United States has the lowest borrowing costs in the world, as governments and other institutions prefer to hold their wealth in dollars and government bonds, the only financial instrument that is not considered to have a risk of default. Over time, these reserves have shifted to other currencies – which could eventually lead to another country becoming the preferred haven for large cash reserves.
“If you’re a central banker and you’re watching this, and it’s kind of a recurring drama, you might say, ‘We love our dollars, but maybe it’s time to hold more euros,'” Marcus Noland said. Executive Vice President at the Peterson Institute for International Economics. “The way I would describe the scenario involving ‘The Perils of Pauline’ is that it just adds an extra boost to this process.”
When do these consequences really begin to increase? In a way, it’s only when investors are moving from accepting a last-minute deal to expecting a default, a point in time that is nebulous and impossible to predict. But a rating agency could make that decision for everyone else, as Standard & Poor’s did in 2011 — even after reaching a deal and raising the debt ceiling — when it downgraded US debt from AAA to AA+, resulting in that stocks fell plummet.
That decision was based on the political rancor surrounding the negotiations, as well as the sheer size of the federal debt — both of which have skyrocketed over the past decade.
It’s not exactly clear what would happen if the X-Date went by without a deal. Most experts say the Treasury Department would continue to make interest payments on the debt and instead delay making other payments, such as payments to government contractors, veterans, or doctors who treat Medicaid patients.
That would prevent the government from immediately defaulting, but could also shake confidence, unleash financial markets and lead to a sharp drop in hiring, investment and spending.
“These are all standard values, just standard values for different groups,” said William G. Gale, an economist at the Brookings Institution. “If they can do it with veterans or Medicaid doctors, ultimately they can do it with bondholders.”
Republicans have proposed combining a debt ceiling hike with drastic government spending cuts. They’ve promised to spare Social Security recipients, Pentagon spending, and veterans’ benefits. But that equation would require significant cuts in other programs — such as housing, toxic waste cleanup, air traffic control, cancer research, and other economically important categories.
The 2011 Budget Control Act, which emerged from that year’s stalemate, ushered in a decade of caps that progressives have criticized for preventing the federal government from responding to new needs and crises.
The economic turmoil from the debt ceiling standoff is emerging as Federal Reserve policymakers seek to contain inflation without triggering a recession — a thorny task with little room for error.
“The Fed is trying to thread a very fine needle,” said Mr. Kroszner, the former Fed economist. “At some point you break the camel’s back. Would that be enough to achieve that? Probably not, but do you really want to take that risk?”