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After the United States hit its debt ceiling on Thursday, the Treasury Department is now taking “extraordinary measures” to keep paying the government’s bills.
A default could be catastrophic and “do irreparable damage to the US economy, the livelihoods of all Americans and global financial stability,” Treasury Secretary Janet Yellen warned.
Yellen told CNN’s Christiane Amanpour on Friday that the effects would be felt by every American.
“If that happened, our borrowing costs would go up, and every American would see their borrowing costs going up, too,” Yellen said. “Furthermore, a failure to make payments due, whether to bondholders or to Social Security recipients or to our military, would undoubtedly cause a recession in the US economy and could cause a global financial crisis.”
She added: “It would certainly undermine the dollar’s role as a reserve currency used for transactions around the world.” And Americans – a lot of people – would lose their jobs and certainly their cost of borrowing would go up.”
Dire warnings about debt ceiling problems are not new. Federal lawmakers have reached agreements in the past, and this Congress has some time — at least until early June, according to Yellen’s public estimates — to reach agreement on whether to raise or suspend the debt ceiling.
Many economists assume that an agreement will be reached. However, given the current “extremely unsettled political environment,” it could be a long process that would contribute to “flares” in financial market volatility, Moody’s Investors Service said in a note Thursday.
Such volatility comes at a time when the Federal Reserve is trying to lower inflation while navigating a soft (or soft) landing with minimal damage to the economy.
So what happens to the economy in a worst-case scenario of a default?
It’s an understandable question with an unsatisfactory answer, said Michael Pugliese, vice president and economist at Wells Fargo’s corporate and investment bank.
“The honest truth is nobody knows,” he said. “We have never seen, and never come close to, a widespread US government default.”
While a default cannot be modeled in the way a more historically common economic event like a recession can be, the events of 2011 might offer some perspective on what would happen if the debt ceiling drama turned into a debacle. said Gregory Daco, chief economist at EY-Parthenon.
“2011 was the first time in a long time that we came close to a debt ceiling,” he said. “And that was a time when there was a lot of policy fragmentation and a strong desire to essentially combine spending cuts with an increase in the debt ceiling.”
The current environment involves a similar risk appetite and desire to cut spending, he said.
But some fear this fight could be tougher than in the past, a concern compounded by the fact that 15 ballots were required to choose the Speaker of the House of Representatives, which is usually the simplest vote of a new Congress.
The economy almost 13 years ago was different too.
At the time, the Fed was in loose monetary policy mode and the economy was in a weaker position, still recovering from the Great Recession of 2008, Pugliese said. Unemployment was over 9% in July 2011.
That same year, the Treasury Department predicted that the “X-date” — the date by which it would be unable to pay its obligations on time — would fall on August 2, 2011. This was ultimately the date that Congress passed and President Barack Obama enacted: a cap-raising law.
The real economic impact of the 2011 debt ceiling hike is difficult to isolate and quantify, Pugliese said, noting that the sluggish US economic recovery has also experienced impacts from global events, particularly the European sovereign debt crisis.
Still, there are some signs that the protracted congressional struggle helped shake up the economy at the time, he said. Real GDP growth in the third quarter of 2011 was a weak -0.1% qoq on an annualized basis. Financial markets were muddled, consumer confidence weakened, the US economic policy uncertainty index hit a new high and Standard & Poor’s The rating agency downgraded the United States from AAA to AA+.
“I think it’s hard for you to say that [the debt ceiling debacle] was a positive thing,” he said. “I see it as just another hurdle among many other hurdles for the economy emerging from 9% unemployment at the time.”
This time, if the X-date comes without a decision, there is speculation that the Treasury Department could prioritize principal and interest payments to prevent a technical failure, Pugliese said. There may be other Treasury and Federal Reserve break-the-glass options, but these are untested and short-term solutions, he added.
“Somebody, somewhere, is going to be left behind if the government doesn’t have all their money, whether that’s Social Security recipients, defense contractors, civil servants, veterans, [etc.],” he said.
Adding to the uncertainty is the current economic climate, Daco said.
“We enter this delicate phase at a time when the US economy is significantly slowing and at a time when the global economic backdrop is also weakening… The economic environment in which this debt ceiling debacle is unfolding is so characterized by an increasing economic slowdown.”
While a self-inflicted recession would be likely after an X-date hits, some upheaval could come sooner, Daco said.
“Financial markets and private sector players tend to react before that date,” he said. “If we are expected to get very close to that drop-dead date, then financial market volatility in general tends to increase and stock prices tend to react negatively.”
A Treasury failure would undermine the global financial system, said Louise Sheiner, policy director at the Hutchins Center on Fiscal and Monetary Policy and a former senior economist at the Fed and the Council of Economic Advisers.
“If government bonds become something that people are afraid to hold, it will impact capital markets around the world in a way that’s really hard to predict,” she said.
Considering the potential fallout in the US and abroad, Sheiner believes the debt ceiling will be lifted or suspended – eventually.
“There’s no other way around it,” she said. “There’s no way Congress is going to cut spending by 20% mid-year. It would plunge the economy into recession. It would be a terrible policy.”
She added, “If you’re going to take care of the long-term debt, you actually have to change various laws, the Social Security Act, Medicare, or the tax law… You want to do it in a proper process, you want to do it well thought out.” You shouldn’t do something like that under duress.”
CNN’s Maegan Vazquez, Matt Egan and Tami Luhby contributed to this report.
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