Congress and the White House are racing to a June 1 deadline to settle a debt ceiling debate, with the full confidence and creditworthiness of the United States at stake.
Treasury Secretary Janet Yellen said that failure to raise or suspend the debt ceiling would result in “economic and financial catastrophe” that would cloud the US economic outlook, which is already clouded by elevated inflation, high interest rates and unease in the banking industry.
The Congressional Budget Office and Treasury Department forecast on May 3 that 500,000 Americans would lose their jobs if the government fails to pay their bills for even a week as the economy shrinks 0.6%.
What is the worst case scenario?
A “persistent” outage lasting more than three months would trigger a Great Recession-like scenario in which up to 8.3 million people could lose their jobs. In this scenario, the stock market could fall 45%, hurting the accounts of those saving for retirement.
Those still working would come under pressure from even higher interest rates. Mortgage rates, for example, could continue to rise, having already risen from around 3% in December 2021 to 6.4% this month.
Economists say these scenarios loom over the US, which is already on the brink of recession. Deutsche Bank is forecasting a recession to begin later this year as a result of the Federal Reserve’s efforts to raise interest rates and deliberately slow down a high-inflation-plagued economy.
Although unemployment is at an all-time low of 3.4%, high inflation is outstripping wage increases. Americans had to tap into their savings to make ends meet. Households saved a total of $1.6 trillion before the pandemic, but are now sitting on savings of just $1 trillion.
Credit card rates, which are up nearly 24% according to LendingTree, take credit card balances to over $986 billion, surpassing the pre-pandemic peak by $59 billion.
Adding to high borrowing costs and fears that the jobs market will soon reverse, the Conference Board’s measure of consumer expectations is at levels “linked to a recession within the next year.”
‘A Main Problem’
A debt ceiling debacle would only worsen that outlook, economists say.
“If you rode over that cliff and the government went technically insolvent, that would be a big problem. It would cause a global crisis,” said Brett Ryan, US senior economist at Deutsche Bank, of a potential default.
The debt ceiling is a legal limit on how much debt the US Treasury Department can issue. The government exceeded that limit on January 19, prompting scrambles to find cash elsewhere to keep the lights on. The Treasury estimates it will exhaust these “extraordinary measures” as early as June 1 — a date that could change depending on hard-to-predict factors like tax payments from last month’s filing deadline.
After June 1, the government would run the risk of defaulting – or failing to pay its debts.
“We would be entering uncharted territory and the implications for the US economy would be highly uncertain and could be quite unfavorable,” the nation’s top economic policymaker, Federal Reserve Chair Jerome Powell, said May 4.
Failure to pay the bills would undermine confidence in the US government debt, which to date is viewed as largely “risk free” as the nation pays off its debts on time and in full. A default could cause US Treasuries, debentures and bonds to fall in value dramatically (thereby increasing the “yield” that their coupons pay out as a percentage of their value).
How important is this return?
Almost every corner of the financial world relies on US government yields as a benchmark. Investors at home and abroad pay close attention to returns when trading securities.
Mortgage lenders look at US Treasuries when deciding what interest to charge you when you buy a home. Third Way estimates that a default could add $130,000 to the cost of an average 30-year mortgage.
The US may not even need to technically default to realize some of these effects. In 2011, credit rating agency S&P downgraded the country’s cherished AAA credit rating due to the “political recklessness” of its debt ceiling considerations. The downgrade, which was never reversed, added an estimated $1.3 billion to the government’s borrowing costs.
Certain corners of the US financial system are now at risk, which would make any negative debt ceiling outcome in 2023 particularly pronounced. Rising government bond yields could worsen the picture for commercial real estate, where telecommuting agreements are putting pressure on interest rates for landlords with mounting debt.
Bank worries are increasing the pressure
The bankruptcies of three of the 30 largest US banks in the last two months alone add to the risks. The collapse of the First Republic Bank on May 1 reignited concerns about the ability of regional banks to survive higher interest rates, a conundrum that could intensify if a debt ceiling standstill pushes US Treasury yields further higher drives and thus allows interest rates to rise further.
Additionally, economists worry that the political air may not be there to respond quickly to an acceleration in banking system troubles if necessary.
“Complicating any future debate about a federal bailout is a looming deadlock over the debt ceiling,” wrote strategists Gary Schlossberg and Jennifer Timmerman of the Wells Fargo Investment Institute on April 25.
And so does politics
Goldman Sachs Economics noted on May 1 that the GOP also includes the 2024 election in any debt ceiling strategy because it “represents the best opportunity for Republicans in Congress to wring policy concessions from the President.”
Although it is a government debt cap mechanism, the debt ceiling does not limit spending. Separate from the debt ceiling, the federal budget process determines how much money the government spends — and what it’s spent on. Still, House Speaker Kevin McCarthy and President Joe Biden remain at odds over how to bring the two together.
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McCarthy is trying to couple a credit limit increase with spending cuts, but Senate Democrats and the White House are committed to a “clean” bill that would raise the debt ceiling — leaving debates on spending to the separate annual budget process.
Despite the impasse, history is on the side of the solution. Since 1960, Congress has attempted to raise or extend the debt limit 78 times.
Deutsche Bank’s Brett Ryan said he expects Congress to pass a short-term extension that would delay the debt ceiling debate until late September, when the economy may already be weak.
“It just increases the likelihood of a recession,” Ryan said.
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