Even flirting with defaults in the US takes an economic toll

As negotiations over a debt limit dragged on in Washington and the time for the US government to stop paying some bills approached, he warned all concerned that such a default would have dire consequences.

But it may not take a default to hurt the US economy.

Even if a deal is struck before the last minute, prolonged uncertainty could drive up borrowing costs and further destabilize already shaky financial markets. It can lead to a decline in investment and employment by businesses when the US economy is already facing high risks of recession, and hamper financing of public works projects.

More broadly, confrontation could erode long-term confidence in the stability of the US financial system, with lasting repercussions.

For now, investors are showing few signs of anxiety. Although markets fell on Friday after Republican leaders in Congress announced a “pause” in negotiations, the declines were modest, suggesting that traders are betting that the parties will eventually reach an agreement – as they have always done before.

But investor sentiment could change quickly as the so-called date X approaches, when the Treasury can no longer pay the government’s bills. Treasury Secretary Janet L. Yellen said the date could arrive as early as June 1. One thing is really going on: As investors fear that the federal government will default on treasury bonds that mature soon, they’re starting to demand higher interest rates because they’re compensated for by greater risk.

If investors lose confidence that leaders in Washington will solve the crisis, they may panic, said Robert Almeida, a global investment analyst at MFS Investment Management.

“Now that the stimulus is fading, the growth is slowing, you’re starting to see all these little fires,” Mr. Almeida said. “It makes an already difficult situation even more stressful. When the herd is in motion, it tends to move quickly and in a violent manner.”

That’s what happened during the debt-ceiling showdown in 2011. Analyzes that followed that default showed that the tumbling stock market evaporated $2.4 trillion of household wealth, which took time to rebuild, and cost taxpayers billions in high interest payments. Today, credit is becoming more expensive, the banking sector is already shaky, and economic expansion is slowing rather than starting.

“2011 was a completely different situation — we were in recovery from the global financial crisis,” said Randall S. Kruszner, a University of Chicago economist and former Federal Reserve official. “In the current situation, where there is a lot of fragility in the banking system, you’re taking more risks. You’re piling fragility on fragility.”

Rising tension can cause problems through a number of channels.

Higher interest rates on federal bonds will lower the borrowing rates for auto loans, mortgages, and credit cards. This causes pain for consumers, who begin accumulating more debt — and taking longer to pay it off — as inflation drives up the cost of living. Increasingly pressing headlines may prompt consumers to back off their purchases, which underpin about 70 percent of the economy.

Although consumer sentiment is getting darker, this can be attributed to a number of factors, including the recent failure of three regional banks. So far, this doesn’t seem to be translating into spending, said Nancy Vanden Houten, chief economist at Oxford Economics.

“I think all of that could change,” Ms Vanden Houten said, “if we get very close to Date X and there is a real fear of not making payments for things like Social Security or interest on debt.”

Suddenly higher interest rates will be an even bigger problem for heavily indebted companies. If they have to roll over loans that will soon fall off, doing so at 7 percent instead of 4 percent could throw off their earnings expectations, prompting a rush to sell shares. A widespread decline in stock prices would further undermine consumer confidence.

Even if markets remain calm, high borrowing costs are draining public resources. An analysis by the Government Accountability Office estimated that the confrontation with the 2011 debt limits raised Treasury borrowing costs by $1.3 billion in fiscal 2011 alone. At the time, the federal debt was about 95 percent of the country’s GDP. Now it’s 120 percent, which means debt servicing could get a lot more expensive.

“Ultimately this will crowd out resources that could be spent on other high-priority government investments,” said Rachel Snyderman, co-director of the Center for Bipartisan Politics, a Washington think tank. “This is where we see the costs of brinkmanship.”

Interrupting the smooth functioning of federal institutions has already caused headaches for state and local governments. Many bonds are issued using the US Treasury’s mechanism known as the “mollusk window,” which closed on May 2 and will not reopen until the debt limit is increased. Public entities that frequently raise money in this way now have to wait, which could disrupt large infrastructure projects if the process continues any longer.

There are also more subtle effects that can outlast the current encounter. The United States has the world’s lowest borrowing costs because governments and other institutions prefer to hold their wealth in dollars and Treasury bills, the only financial instrument believed to have no default risk. Over time, those reserves began to convert into other currencies – which could eventually make another country the preferred haven for large reserves of cash.

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

When do these consequences actually start to worsen? In a sense, just when investors move from assuming a last-minute deal to expecting a default, a point in time is murky 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 reaching an agreement and raising the debt limit – when it downgraded the US debt rating to AA+ from AAA, causing the stock rating to drop to AA+ from AAA. He is drowning.

This decision was based on the political rancor that surrounded the negotiations, as well as the sheer size of the federal debt—both of which had ballooned in the ensuing decade.

It is not clear exactly what would happen if Date X passed without an agreement. Most experts say the Treasury will continue making interest payments on the debt and instead delay fulfilling other obligations, such as payments to government contractors, veterans or doctors who treat Medicaid patients.

This would prevent the government from defaulting on debt immediately, but it could also shatter confidence, roiling financial markets, and triggering sharp declines in employment, investment and spending.

“These are all assumptions, just defaults of different groups,” said William G. Gill, an economist at the Brookings Institution. “If they can do it for veterans or Medicaid doctors, they can finally do it for bondholders.”

Republicans have proposed pairing an increase in the debt limit with sharp cuts in government spending. They vowed to spare Social Security recipients, Pentagon spending and veterans’ benefits. But that equation requires deep cuts in other programs—such as housing, toxic waste cleanup, air traffic control, cancer research, and other economically important categories.

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

The economic turmoil from facing the debt ceiling comes as Federal Reserve policymakers try to tame inflation without triggering a recession, a delicate task with little margin for error.

“The Fed is trying to poke a very fine needle,” said Mr. Kreuzner, a former Fed economist. “At some point, you break the camel’s back. Will that be enough to do it? Probably not, but do you really want to take that risk?”

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