Holding the Debt Ceiling Hostage Threatens the Economy
By MICHAEL PATON
What would happen if the U.S. government defaulted on its national debt?
The Federal government has a borrowing constraint commonly known as the debt ceiling. It represents the total amount of aggregate debt owed by the U.S. government to the rest of the world. When that ceiling is reached, the Treasury Department cannot issue any more debt in the form of treasury securities. On Jan. 19, 2023, the U.S reached its debt ceiling when the national debt increased to approximately $31.4 trillion. Until Congress increases it again, the Treasury Department is relying on extraordinary measures to meet the government’s bond and note obligations. However, these measures cannot go on indefinitely, and the government may be at risk of default later this year if the Congress does not act, if Congress doesn’t raise the debt ceiling, the government may be forced to choose
between paying federal employees’ salaries, Social Security benefits or the interest on the national debt. If the interest isn’t paid, the government is in technical default
In January 2013, Congress threatened not to raise the debt ceiling. Back then, the brinksmanship led to a federal government shutdown, where all but essential government offices were closed. Because of the political impasse in Congress, on the first day of fiscal year 2014 (Oct. 1, 2013), the government shut down as Congress hadn’t approved the funding bill. On Oct. 17, 2013, Congress finally agreed to a deal that would let the Treasury issue debt until Feb. 7, 2014.
The Council of Economic Advisers estimated that the combination of the government shutdown and debt limit brinksmanship resulted in 120,000 fewer private-sector jobs created during the first two weeks of October and slowed economic growth by as much as 0.6%.
According to WealthManagement.com, a financial services and wealth management consultant, uncertainty regarding the current debt limit could have serious economic consequences. In the case of a complete U.S. default, there are few precedents to rely on to help forecast what could happen. Although other countries have defaulted on their sovereign debt, those defaults occurred in situations when countries could not feasibly continue to service their debt. However, other nations that have defaulted are not the world’s leading reserve currency—the dollar. Putting it mildly, the world’s economy is tied to the U.S. and the global financial system is tied to the U.S. dollar.
In the case of a prolonged default, liquidity in financial markets could be severely impaired. Default might increase the reluctance of investors to hold Treasury securities and dollar-denominated assets in general, leading to a higher risk premium on all U.S. assets and a decline in the dollar. Given a default and assuming the Treasury prioritizes its payments to cover all scheduled net interest payments, Federal spending on such important programs as Social Security, Medicare/Medicaid, veterans benefits and other transfer programs would have to be temporarily reduced. While shortfalls in disbursements would probably be made up later, consumer spending would fall in the meantime. The multiplier effects could lead to a sharp recession in the economy.
A 2013 report by the Federal Reserve noted several possible consequences of a relatively short default. They estimated that a default could result in a one-month furlough of workers that would impede federal spending (and hence real GDP) that would not be made up. This effect would shave 0.75 percentage point from the annual rate of real GDP growth in that quarter. Ten-year Treasury yields would rise about 80 basis points and BBB corporate bond yields would increase about 220 basis points; stock prices would fall by about 30%; the dollar would drop by about 10%.
In general, a default would prompt a tightening in credit availability as well as a reduction in household and business confidence that would accompany the deterioration in financial conditions. Private spending would fall sharply, about one-third to one-half as large as the fall during the Great Recession (late 2008 and early 2009). The default would send shock waves through the domestic and global economies, threatening the supremacy of the U.S. dollar. In a worse-case scenario the global banking system would destabilize, leading to major bank failures. It is unlikely that the Federal Reserve could backstop an event of this magnitude.
In summary, the risks to the economy and financial markets of a prolonged default are almost unthinkable, especially given the simple solution of Congressional passage. That is why we have never had a default. Unfortunately, given the current situation with a narrowly divided Congress, treating even a highly unlikely event as impossible is a mistake that politicians and investors cannot afford to make.
About the author: Michael J. Paton is a portfolio manager at Tocqueville Asset Management L.P. He joined Tocqueville in 2004. He manages balanced portfolios and is a member of the fixed-income team. He can be reached at (212) 698-0800 or by email at [email protected].