Why Hitting the Debt Ceiling Would Be Very Bad for the U.S. Economy

WASHINGTON — Washington and Wall Street are bracing for a revival of brinkmanship over the nation’s statutory debt limit, raising fears that the fragile U.S. economy could be rattled by a calamitous self-inflicted wound.

For years, Republicans have sought to tie spending cuts or other concessions from Democrats to their votes to lift the borrowing cap, even if it means eroding the world’s faith that the United States will always pay its bills. Now, back in control of a chamber of Congress, Republicans are poised once again to leverage the debt limit to make fiscal demands of President Biden.

Treasury Secretary Janet L. Yellen warned on Friday that she would have to undertake “extraordinary measures” to continue paying the nation’s bills beyond January if lawmakers did not act to raise the debt limit — and that her powers to delay a default could be exhausted by early June.

The fight over the debt limit is renewing debates about what the actual consequences would be if the United States were unable to borrow money to pay its bills, including what it owes to the bondholders who own U.S. Treasury debt and essentially provide a line of credit to the government.

Some Republicans argue that the ramifications of breaching the debt limit and defaulting are overblown. Democrats and the White House — along with a variety of economists and forecasters — warn of dire scenarios that include a shutdown of basic government functions, a hobbled public health system, and a deep and painful financial crisis.

Speaker Kevin McCarthy signaled that he and his fellow Republicans would seek to use the debt limit standoff to enact spending cuts and reduce the national debt. He said that lawmakers very likely had until summertime to find a solution before the United States runs out of cash, a threshold that is known as “X-date.”

“One of the greatest threats we have to this nation is our debt,” Mr. McCarthy said on Fox News, adding, “We don’t want to just have this runaway spending.”

Mr. Biden has repeatedly said that he will refuse to negotiate over the debt limit, and that Congress must vote to raise it with no strings attached.

That has introduced the very real likelihood of a debt limit breach. “Fiscal deadlines will pose a greater risk this year than they have for a decade,” economists at Goldman Sachs wrote in a note.

Here’s a look at what the debt limit is and why it matters.

The debt limit is a cap on the total amount of money that the federal government is authorized to borrow to fulfill its financial obligations. Because the United States runs budget deficits — meaning it spends more than it brings in through taxes and other revenue — it must borrow huge sums of money to pay its bills. That includes funding for social safety net programs, interest on the national debt and salaries for troops.

After a protracted standoff in late 2021, Congress agreed to raise the borrowing cap to $31 trillion.

Although the debt ceiling debate often elicits calls by lawmakers to cut back on government spending, lifting the debt limit does not authorize any new spending and in fact simply allows the United States to finance existing obligations. In other words, it allows the government to pay the bills it has already incurred.

Ms. Yellen’s declaration that a default could loom as early as June signaled that there was less time to resolve the matter than some had estimated even recently.

Analysts at Goldman Sachs had put the date around August. The Bipartisan Policy Center, which closely tracks the debt limit deadline, projected last summer that the X-date would likely arrive no sooner than the third quarter of 2023.

The actual moment when the federal government can no longer fully meet its obligations on time, if it arrives, will be a function of the Treasury Department’s cash flow, which could change depending on the trajectory of the economy and the fate of certain policies.

Just approaching a breach of the debt limit can hurt the economy. In 2011, congressional Republicans and President Barack Obama engaged in a standoff over spending and debt that was resolved just in time to avoid hitting the limit. That brinkmanship rattled investors, consumers and business owners, with concrete consequences.

Stock prices plunged — and volatility in the market spiked — as lawmakers approached a debt limit breach. They did not recover for half a year. The cost of borrowing for corporations, which fluctuates with the level of risk that investors perceive in the economy, jumped substantially. That made it more expensive for companies to borrow to make new investments. Mortgage rates spiked similarly, hampering prospective home buyers. The credit agency S&P downgraded America’s credit rating for the first time.

Consumer confidence and small-business optimism both plunged during the crisis, as well.

An actual breach would be far worse, economists warn.

If the Treasury Department is unable to make payments to lenders who hold federal debt — what is known as a default — investors would demand much higher interest rates in the future to loan money to the government. It would be similar to what happens when borrowers miss credit card payments — their credit ratings go down, and the interest rate they pay often goes up.

Such a scenario would add drastically to the government’s interest payments, which the White House projects will cost the equivalent of 2.6 percent of the total American economy over the next decade, further squeezing the federal budget. It would also threaten to destabilize bond markets globally because U.S. Treasury bonds are largely seen as one of the safest investments in the world.

That spiral would most likely occur even if the government maintains its payments to bondholders but is unable to pay other bills, like salaries for federal workers.

Perhaps most immediately damaging to an already fragile U.S. recovery, the government would pull a huge amount of spending power out of the economy overnight if it breached the borrowing limit. By choosing not to pay some combination of Social Security checks, federal workers, bondholders and more, the government would be immediately killing the equivalent of one-tenth of American economic activity, Goldman Sachs analysts have estimated.

“It’s a large amount,” said Alec Phillips, Goldman’s chief political economist. “You just take 10 percent of the economy out of play for a bit until you resolve it.”

Researchers at Third Way, a Democratic think tank, estimated in December that a debt limit breach could kill up to three million jobs, add $130,000 to the cost of an average 30-year mortgage and balloon the national debt by an additional $850 billion.

As a first step, to ward off default, Ms. Yellen said she would begin suspending new investments in the Civil Service Retirement and Disability Fund and the Postal Service Retiree Health Benefits Fund, and suspending reinvestment in the Government Securities Investment Fund of the Federal Employees Retirement System’s Thrift Savings Plan to avoid breaching the debt limit.

In the past, Treasury officials have discussed trying to prioritize certain payments — like military salaries — or delaying payments entirely for a certain period until the government has sufficient revenue to cover all of its bills. Either scenario would cause chaos in the financial markets and set off legal challenges.

In late 2021, about a dozen officials in the department’s Office of Fiscal Projections were tracking the size and timing of the nation’s inflows and outflows of money to refine its estimates for the so-called X-date. They kept close tabs on fluctuations in nonmarketable debt, such as savings bonds, and coordinated closely with government agencies to determine their spending needs.

Treasury officials also prepared for when they might have to conserve cash and suspend the daily reinvestment of Treasury securities held by the Exchange Stabilization Fund, a pot of emergency money that is supposed to be used to intervene in currency markets during times of turmoil. That is the last step before the agency’s fiscal accounting maneuvers, known as extraordinary measures, would likely be exhausted.

Containing that fallout from a default would initially be the responsibility of the Federal Reserve.

The central bank has a playbook for dealing with a debt ceiling breach that was laid out during conference calls and meetings in 2011 and 2013.

In the 2011 congressional standoff, central bankers held a call to discuss what the Fed could do to rescue the financial system.

The options included treating defaulted Treasury bonds the same as bonds that have not defaulted when it came to Fed operations that purchased government debt or accepted it as collateral, “so long as the default reflects a political impasse and not any underlying inability of the United States to meet its obligations,” according to the transcripts of that call. The Fed also suggested that it could support money market mutual funds, as shorter-term debt markets faced widespread disruptions.

Most notably, the Fed’s staff suggested that the central bank could specifically purchase defaulted Treasury bonds, essentially paying off bondholders in a bid to keep markets functioning.

And it discussed buying defaulted bonds while selling off unaffected ones — though transcripts show that officials worried that “such an approach could insert the Federal Reserve into a very strained political situation and could raise questions about its independence from debt management issues faced by the Treasury.”

Jerome H. Powell, who is now the Fed’s chair, once called the possibility of purposely buying defaulted Treasury debt “loathsome.”

When the debt ceiling again emerged as a problem in 2013, Mr. Powell, who was then a Fed governor, worried that the central bank might make default more likely by advertising that it had a solid plan for dealing with one.

“If it actually looks like a good game plan, then it will make it less likely that the Congress will feel enough pressure to actually raise the ceiling,” he warned in a strategy call that October.

But he added, “I don’t want to say today what I would and wouldn’t do, if we have to actually deal with a catastrophe on this.”

Ms. Yellen has dismissed the viability of theoretical ideas to raise the debt limit, such as minting a trillion-dollar coin. But she has called for abolishing the statutory debt limit entirely, warning that the borrowing cap was “destructive” to the U.S. economy and arguing that it was blocking the federal government from spending money that Congress had already authorized.

Thus far, that recommendation has gone unheeded by Congress. Doing away with the debt limit, it seems, is even harder than raising it.

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