Even Flirting With U.S. Default Takes Economic Toll

Lydia DePillis and Ben Casselman

Sun, May 21, 2023 at 9:19 AM CDT


NEW YORK — As negotiations over the debt limit continue in Washington and the date on which the U.S. government could be forced to stop paying some bills draws closer, everyone involved has warned that such a default would have catastrophic consequences.

But it might not take a default to damage the U.S. economy.

Even if a deal is struck before the last minute, the long uncertainty could drive up borrowing costs and further destabilize already shaky financial markets. It could lead to a pullback in investment and hiring by businesses when the U.S. economy is already facing elevated risks of a recession and hamstring the financing of public works projects.

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More broadly, the standoff could diminish long-term confidence in the stability of the U.S. financial system, with lasting repercussions.

Currently, investors are showing few signs of alarm. Although markets fell Friday after Republican leaders in Congress declared a “pause” on negotiations, the declines were modest, suggesting that traders are betting that the parties will come to an agreement in the end — as they always have before.

But investor sentiment could shift quickly as the so-called X-date, when the Treasury can no longer keep paying the government’s bills, approaches. Treasury Secretary Janet Yellen has said the date could arrive as early as June 1. One thing that’s already happening: As investors fret that the federal government will default on Treasury bonds that are maturing soon, they have started to demand higher interest rates as compensation for greater risk.

If investors lose faith that leaders in Washington will resolve the standoff, they could panic, said Robert Almeida, a global investment strategist at MFS Investment Management.

“Now that the stimulus is fading, growth is slowing, you’re starting to see all these little mini-fires,” Almeida said. “It makes what is already a difficult situation more stressful. When the herd moves, it tends to move really fast and in a violent way.”

That’s what happened during a debt ceiling standoff in 2011. Analyses after that near-default showed that the plunging stock market 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 an economic expansion is tailing off rather than beginning.

“2011 was a very different situation. We were in recovery mode from the global financial crisis,” said Randall S. Kroszner, a University of Chicago economist and former Federal Reserve official. “In the current situation, where there’s a lot of fragility in the banking system, you’re taking more of a risk. You’re piling up fragility on fragility.”

The mounting tension could cause problems through a number of channels.

Rising interest rates on federal bonds will filter into borrowing rates for auto loans, mortgages and credit cards. That inflicts pain on consumers, who have started to rack up more debt — and are taking longer to pay it back — as inflation has increased the cost of living. Increasingly urgent headlines might prompt consumers to pull back on their purchases, which power about 70% of the economy.

Although consumer sentiment is darkening, that could be attributed to a number of factors, including the recent failure of three regional banks. And so far, it doesn’t appear to be spilling over into spending, said Nancy Vanden Houten, a senior economist for Oxford Economics.

“I think all this could change,” Vanden Houten said, “if we get too close to the X-date and there is real fear about missed payments for things like Social Security or interest on the debt.”

Suddenly higher interest rates would pose an even bigger problem for highly indebted companies. If they have to roll over loans that are coming due soon, doing so at 7% instead of 4% could throw off their profit projections, prompting a rush to sell stocks. A widespread decline in share prices would further erode consumer confidence.

Even if the markets remain calm, higher borrowing costs drain public resources. An analysis by the Government Accountability Office estimated that the 2011 debt limit standoff raised the Treasury’s borrowing costs by $1.3 billion in the 2011 fiscal year alone. Back then, the federal debt was about 95% of the nation’s gross domestic product. Now it’s 120%, which means servicing the debt could become a lot more expensive.

“It eventually will crowd out resources that can be spent on other high-priority government investments,” said Rachel Snyderman, a senior associate director of the Bipartisan Policy Center, a Washington think tank. “That’s where we see the costs of brinkmanship.”

Interrupting the smooth functioning of federal institutions has already created a headache for state and local governments. Many issue bonds using a U.S. Treasury mechanism known as the “Slugs window,” which closed May 2 and will not reopen until the debt limit is increased. Public entities that raise money frequently that way now have to wait, which could hold up large infrastructure projects if the process drags on longer.

There are also more subtle effects that could outlast the current confrontation. The United States has the lowest borrowing costs in the world because governments and other institutions prefer to hold their wealth in dollars and Treasury bonds, the one financial instrument thought to carry no risk of default. Over time, those reserves have started to shift into other currencies — which could eventually make another country the favored harbor for large reserves of cash.

“If you are a central banker, and you’re watching this, and this is a kind of recurring drama, you may say that ‘we love our dollars, but maybe it’s time to start holding more euros,’” said Marcus Noland, executive vice president at the Peterson Institute for International Economics. “The way I would describe that ‘Perils of Pauline,’ short-of-default scenario is that it just gives an extra push to that process.”

When do these consequences really start to mount? In one sense, only when investors shift from assuming 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 reached and the debt limit was raised — when it downgraded the U.S. debt to AA+ from AAA, causing stocks to plunge.

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 ballooned in the intervening decade.

It isn’t clear exactly what would happen if the X-date passed with no deal. Most experts say the Treasury Department would continue to make interest payments on the debt and instead delay fulfilling other obligations — such as payments to government contractors, veterans or doctors who treat Medicaid patients.

That would prevent the government from immediately defaulting on the debt, but it could also shatter confidence, roiling financial markets and leading to a sharp pullback in hiring, investment and spending.

“Those are all defaults, just defaults to different groups,” said William G. Gale, an economist at the Brookings Institution. “If they can do that to veterans or Medicaid doctors, they can eventually do it to bondholders.”

Republicans have proposed pairing a debt limit increase with sharp cuts in government spending. They have pledged to spare Social Security recipients, Pentagon spending and veterans’ benefits. But that equation would require steep reductions in other programs — like housing, toxic waste cleanup, air traffic control, cancer research and other categories that are economically important.

The 2011 Budget Control Act, which resulted from that year’s standoff, led to a decade of caps that progressives have criticized for preventing the federal government from responding to new needs and crises.

The economic turbulence from the debt ceiling standoff comes as Federal Reserve policymakers are trying to tame inflation without causing a recession, a delicate task with little margin for error.

“The Fed is trying to thread a very fine needle,” said Kroszner. “At some point, you break the camel’s back. Would this be sufficient to do that? Probably not, but do you really want to take that risk?”

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