As debt limit talks continue in Washington and the date when the US government may be forced to stop paying some bills approaches, all concerned are warning that such a default would have catastrophic consequences.
But a default may not be necessary to hurt the US economy.
Even if a deal closes before the last minute, the long-standing uncertainty could drive up borrowing costs and further destabilize already shaky financial markets. This could lead to a pullback in business investment and hiring when the US economy already faces heightened risks of recession and make it difficult to finance public works projects.
More broadly, the stalemate could undermine long-term confidence in the stability of the US financial system, with lasting repercussions.
Currently, investors are showing few signs of alarm. While markets fell on Friday after Republican leaders in Congress declared a “pause” in talks, the declines were modest, suggesting traders are betting the parties will reach an agreement in the end – as they always have before.
But investor sentiment could change quickly as the so-called X date approaches, when the Treasury can no longer continue to pay government bills. Treasury Secretary Janet L. Yellen said the date could come as early as June 1. compensation for greater risk.
If investors lose faith that leaders in Washington will resolve the impasse, they could panic, said Robert Almeida, global investment strategist at MFS Investment Management.
“Now that stimulus is fading, growth is slowing, you’re starting to see all these little fires,” Almeida said. “It makes what is already a difficult situation more stressful. When the herd moves, it tends to move very fast and violently.”
That’s what happened during a stalemate over the debt ceiling in 2011. Analysis after the near-default showed that the stock market crash vaporized $2.4 trillion in household wealth, which took time to rebuild and cost taxpayers billions. in higher interest payments. Today, credit is more expensive, the banking sector is already shaken, and economic expansion is slowing rather than starting.
“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 there is a lot of fragility in the banking system, you are taking more risks. You are piling fragility upon fragility.”
Rising voltage can cause problems through many channels.
Higher interest rates on federal bonds will affect rates on auto finance, mortgages and credit cards. This hurts consumers, who have started accumulating more debt – and are taking longer to pay it off – as inflation has raised the cost of living. Increasingly urgent headlines could prompt consumers to cut back on their purchases, which fuel about 70% of the economy.
While consumer sentiment is deteriorating, this can be attributed to a number of factors, including the recent failure of three regional banks. And so far, it doesn’t seem to be hurting spending, said Nancy Vanden Houten, senior economist at Oxford Economics.
“I think that all could change,” said Vanden Houten, “if we get too close to the X-date and there’s a real fear of missed payments for things like Social Security or interest on the debt.”
Suddenly higher interest rates would pose an even bigger problem for heavily indebted companies. If they have to roll over loans coming due soon, doing so at 7% instead of 4% could hurt their profit projections, leading to a rush to sell stock. A general drop in stock prices would further erode consumer confidence.
Even if markets remain calm, higher borrowing costs drain public resources. An Office of Government Accountability analysis estimated that the 2011 debt limit impasse raised Treasury borrowing costs by $1.3 billion in fiscal 2011 alone. % of the country’s gross domestic product. Now it’s 120%, which means debt service could get a lot more expensive.
“In the end, it will crowd out resources that can be spent on other high-priority government investments,” said Rachel Snyderman, senior associate director at the Bipartisan Policy Center, a Washington think tank. “That’s where we see the costs of brinkmanship.”
The disruption of the smooth functioning of federal institutions has already created a headache for state and municipal governments. Many issue bonds using a US Treasury mechanism known as the “Slugs window,” which closed on May 2 and will not reopen until the debt limit is raised. Public entities that frequently raise money this way now have to wait, which could delay large infrastructure projects if the process drags out any longer.
There are also more subtle effects that can last longer than the current encounter. The United States typically enjoys low borrowing costs because governments and other institutions prefer to hold their wealth in dollars and Treasury bills, the only financial instrument deemed risk-free. Over time, these reserves began to shift into other currencies – which could eventually make another country the preferred haven for large cash reserves.
“If you’re a central banker and you’re watching this, and this is a kind of recurring drama, you might say, ‘We love our dollars, but maybe it’s time to start having more euros,’” said Marcus Noland, vice president. executive chairman of the Peterson Institute for International Economics. “The way I would describe this ‘Perils of Pauline’ scenario is that it just gives that process an extra boost.”
When do these consequences really start to mount? In a sense, only when investors move from taking a last minute deal to anticipating a default, a point in time that is nebulous and impossible to predict. But a credit rating agency could also make that decision for everyone else, as Standard & Poor’s did in 2011 – even after a deal was struck and the debt limit was raised – when it downgraded US debt to AA+ from AAA, sending the stock down. dive.
This decision was based on the political rancor surrounding the negotiations, as well as the size of the federal debt – both of which increased over the next decade.
It’s unclear exactly what would happen if date X passes without a deal. Most experts say the Treasury Department will continue to make interest payments on the debt and will instead delay meeting other obligations, such as payments to government contractors, veterans or doctors treating Medicaid patients.
That would prevent the government from immediately defaulting on debt, but it could also shake confidence, roiling financial markets and leading to a sharp downturn in hiring, investment and spending.
“It’s all defaults, just defaults by different groups,” said William G. Gale, an economist at the Brookings Institution. “If they can do it with veterans or Medicaid doctors, they can eventually do it with bondholders.”
Republicans have proposed pairing a debt limit hike with sharp cuts in government spending. They promised to save Social Security recipients, Pentagon spending, and veterans’ benefits. But that equation would require steep reductions 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 resulted from that year’s impasse, ushered in a decade of limits that progressives have criticized for preventing the federal government from responding to new needs and crises.
The economic turmoil stemming from the debt ceiling stalemate comes at a time when Federal Reserve policymakers are trying to tame inflation without causing a recession, a delicate task with little room for error.
“The Fed is trying to use a very fine needle,” said Kroszner, the former Fed economist. “At some point, you break the camel’s back. Would that be enough to do that? Probably not, but do you really want to take that risk?”
Audio produced by Parin Behrooz.
