A deal in the coming days to raise the country’s debt limit will not necessarily be an entirely clear signal for the US economy.
Certainly, it would avert the “economic and financial disaster” envisioned by Treasury Secretary Janet Yellen. This doomsday scenario depicts global financial markets in turmoil, mortgage rates skyrocketing, seniors losing their Social Security checks, and millions of jobs being wiped out.
But the 11-hour deal that narrowly avoids default but dampens nerves, sinks stocks and raises interest rates could do some damage, as similar standoffs did in 2011 and 2013, and even tip the weak economy into recession. This is far more likely than a debt limit breach leading to financial disaster.
“The economy is already very fragile and on the brink of recession,” says Mark Zandi, chief economist at Moody’s Analytics, who is among the minority of economists who expect the US to avoid deflation this year.
Zandi says that if a bleak, mediocre convention upsets already volatile markets, a recession is “highly likely.”
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What is the debt ceiling?
The debt ceiling is the maximum amount the government can borrow to pay for everything from Medicare benefits and military salaries to payments it owes bondholders for past debts. The deal and the approval vote do not mean extra spending. It only raises the total amount the government can borrow to pay commitments that Congress has already passed.
If the limit is not raised, the government will have to scramble to pay the bills with only the revenue it brings in from taxes. That would force the Biden administration to decide whether to pay Social Security recipients and federal employees or bondholders who lent money to the government.
A default might occur if the United States failed to make payments to bondholders, but not financing other government expenditures would hurt the economy.
Yellen said the government could run out of money to pay its bills as early as June 1 if Congress does not lift the country’s borrowing authority, giving President Biden and Republican lawmakers just over two weeks to reach an agreement. Republicans are calling for sharp spending cuts, but Biden says such budget bargaining should not be tied to the debt ceiling.
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What happened to the debt ceiling in 2011 and 2013?
In 2011, Republicans similarly demanded that President Obama agree to reduce the deficit in exchange for an increase in the debt ceiling. An agreement was reached on July 31, just two days before the government’s borrowing authority ran out. Despite the deal, brinkmanship created uncertainty about the nation’s creditworthiness and prompted Standard & Poor’s to downgrade the United States’ credit rating for the first time in history.
The S&P 500 stock index fell about 17% during the episode and didn’t recover until the following year, according to a Treasury report, reducing the family’s wealth by $2.4 trillion. Consumer and business confidence slumped and did not fully rebound for several months, after the debt ceiling deal was reached. Borrowing costs, such as mortgages, have gone up. The Treasury report said consumer and business spending declined.
Finally, the crisis caused the ailing economy still recovering from the Great Recession of 2007-2009 to contract at an annualized rate of 0.16% in the third quarter, Zandi estimates. He believes that without it, the economy would have expanded by 2.6%. He believes the impasse has led to a 0.3 percentage point rise in the unemployment rate and 340,000 jobs cut.
A similar standoff also set in fall 2013, as Congress raised the debt ceiling a day before the October 17 deadline. In early October, with no deal in sight, the federal government partially shut down and hundreds of thousands of federal workers were furloughed.
Zandi estimates that the crisis reduced GDP growth in the fourth quarter of 2013 by half a percentage point, with about half of the losses resulting from partial lockdowns and the remainder due to a cloud of uncertainty that dampened consumer and business confidence and spending.
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How bad can the debt ceiling drama hurt the economy?
Even if an agreement is reached, the impasse has created some uncertainty. Short-term Treasury yields maturing after June 1 rose. The cost of credit default swaps – insurance in case the US defaults – is at record levels. Stock markets in general have taken the struggle in stride but have been more volatile in recent days as the deadline approaches.
Assuming the debt limit is not violated, the White House estimates that an 11-hour agreement could still increase borrowing costs and hurt investment by:
- Cut third-quarter GDP growth by 0.3 percentage points.
- Cutting employment by 200,000 jobs.
Zandi agrees – if an agreement is reached by late next week. Under a likely scenario, the two sides could agree to raise the debt limit for a few months and then fight to raise it again in September before the end of the fiscal year at the same time they negotiate the 2024 fiscal budget, Zandi says. That would allow Biden to say the debt limit and spending talks are separate. But postponing the conflict to late summer could mean continued uncertainty that could dampen the economy.
If the drama continues within a day or two of the June 1 deadline, stocks could drop dramatically and the economic fallout could look similar to 2011, Zandi says, implying:
- GDP will fall by more than two percentage points.
- Employment will be reduced by a few hundred thousand jobs.
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How does cutting spending harm the economy?
Oxford Economics also predicted a deal before the deadline that could hurt the economy, but for a different reason. If Biden agrees to $2.4 trillion in spending cuts — just over half the amount Republicans are asking for — that would turn a mild recession into a severe one, says Nancy Vanden Houten, an Oxford economist.
What will happen next?
- GDP will fall by 2.3 percentage points in the second half of the year instead of the 1.5 percentage points that Oxford had predicted.
- Ryan Sweet, chief US economist at Oxford, says an additional 460,000 jobs will be eliminated.
What happens if the debt ceiling is reached?
If Biden and GOP representatives fail to reach an agreement by the deadline:
- Stocks are likely to explode.
- Interest rates on mortgages, corporate bonds and other loans could rise, Moody’s estimates.
In the event of a breach of the short-term debt limit that Congress pays to resolve within a week, here’s what would happen:
- GDP will decline by 0.7 percentage points from peak to trough
- 1.5 million jobs will be laid off
- Unemployment will rise from 3.4% to nearly 5%, according to Moody’s estimates.
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What if the debt ceiling crisis continues for weeks or months?
In a prolonged breach of the debt limit, Moody’s says, “The blow to the economy would be catastrophic.”
- The federal government will have to cut expenditures as money runs out and credit rating agencies downgrade Treasury debt.
- Banks will be reluctant to lend and households and firms will sharply withdraw spending and investment.
- GDP will decline by 4.6 percentage points.
- The unemployment rate will rise to 8%.
- It will lose 7.8 million jobs, plunging the United States into a deep recession, Moody’s estimates.
Even a decade from now, the research firm says, GDP will be roughly a percentage point lower and there will be 1.2 million fewer jobs than if the crisis had not occurred.
Contributing: Anna Kaufman
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