While a chicken game is playing out in Washington, DC over whether to raise the US government’s borrowing limit to avoid a default, experts agree that a default would be catastrophic.
The United States hit its borrowing limit on January 19th. Since then, the US Treasury has taken a number of measures to avoid defaulting, but it is only a matter of days or weeks at most before these are exhausted and the US government is unable to pay its debt.
Here is an explanation of what happens when this unprecedented event occurs.
What are the odds that the US will actually default?
Nobody really knows because it’s “a political issue,” Lawrence J. White, an economics professor at New York University’s Stern School of Business, told Al Jazeera.
“I still hope there will be a solution, but that’s a chicken game and usually someone dodges and a head-on collision is avoided … but sometimes people go over the cliff and that’s the big concern,” he said.
To avoid a default, Congress would have to raise the debt ceiling, but Republicans are demanding spending cuts to do so. President Joe Biden, a Democrat, wants a simple vote in Congress that would only deal with raising the government’s debt ceiling.
Concerns about the deadlock have intensified in recent days as the so-called X-date – when the Treasury would run out of money to pay its bills – was pushed back to as early as June 1 from mid-August due to low tax collections in the April, Bernard Yaros, deputy director at Moody’s Analytics, told Al Jazeera.
If the Treasury can lag until mid-June, Yaros said, there will be a “surge” in tax revenues from businesses and individuals and nearly $150 billion in new extraordinary measures that will help it keep cash flowing through late July or even early July August.
But it’s not clear it will get that respite.
What is the worst case scenario?
The US is heading into a weeks-long default with Republicans and Democrats hot on their heels.
Such a situation would be “a catastrophic scenario” followed by a recession on the scale of the 2008 financial crisis, Yaros said.
In such a scenario, the federal government would have to immediately cut its spending and cut government spending.
While these cuts affected the economy, “the impact on growth would be overwhelming,” Yaros and several Moody’s colleagues said in an analysis published in March.
Aside from that, financial markets would rumble, interest rates would continue to rise and the dollar’s strength would ebb, White said.
As the political deadlock drags on, interest rates will soar even higher, discouraging people from borrowing or investing, White said.
“It’s going to resonate around the world,” he said. “It’s no good for anyone”
A short break
Even if the US fails to meet its commitments for just a few days, this would have consequences for the economy.
“The world will say that we can’t rely on the US Treasury as much as we used to, and that will make people hesitant to hold Treasuries,” White said.
“Interest rates on Treasury bills and bonds will go up, and that will eventually lead to a greater tax burden on Americans.”
It could also fuel calls for alternatives to the US dollar, which has been the unprecedented currency in international finance for decades.
Although it is unclear whether rating agencies would downgrade government bonds if they failed to meet their commitments, any downgrade would trigger a cascade of credit rating implications and downgrades in the debt of many other financial institutions, non-financial corporations, municipalities, infrastructure providers, structured finance transactions and other debt issuers , Moody’s has warned.
Those institutions backed by the US government — including mortgage lenders Fannie Mae, Freddie Mac and the Federal Home Loan Bank — would likely suffer the biggest rating downgrades.
“Despite lawmakers’ quick reversal in this scenario, and our assumption that rating agencies will not downgrade, significant damage will already have been done,” Moody’s said.
“The fact that we haven’t even resolved that position is not good,” White said.
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