Economists are becoming increasingly concerned that the US will generate fresh turbulence in the coming weeks when it hits its debt ceiling and is unable to pay all its bills.
With the two main political parties unable to agree an increase in the $31.4tn ceiling on US federal debt, Janet Yellen, Treasury secretary, has warned that stop-gap measures to circumvent the limit will run out of road as soon as June 1.
At that point, the US federal government would face various unpalatable options, ranging from delaying payments to contractors, social security recipients, Medicare providers or agencies; to defaults on payments on US government debt. It could also carry on spending programmes in defiance of the ceiling.
In any of these scenarios, analysts believe a political, financial and economic crisis would be hard to avoid.
While the congressional disputes are the most serious for at least a decade, Mohamed El-Erian, president of Queens’ College at Cambridge university, said the expectation was still that a last-minute deal would be struck between Democrats and Republicans. If that failed, “we should expect another layer of financial volatility in a system that has already lost many of its anchors”.
“It would come at a time when the global system is facing growth and inflation headwinds, and is also keen to contain the banking tremors to a particular sector of the US system,” he added.
Nathan Sheets, global head of international economics at Citigroup and a former US Treasury official, said: “It amplifies all the other concerns that people have.” There was a “multiplicative kind of effect with the debt ceiling, where people are a little more on edge and they’re a little bit more nervous about this kind of systemic risk”.
The last time the US was so close to hitting the debt ceiling was in 2011. Even though a deal was eventually struck, four days later Standard & Poor’s, the credit rating agency, stripped the AAA rating from US government debt. The downgrade sent US share prices down more than 5 per cent in a day and exacerbated the deepening eurozone crisis.
Michael Feroli, chief US economist at JPMorgan Chase, said that in some ways, particularly with lower unemployment, the US economy was stronger now. However, hitting the debt ceiling would still mark a destabilising blow. “If you have a flu, you don’t want to get hit by a bus. But you never want to get hit by a bus,” he said. “Even if the economy is looking a little bit different [than 2011], it’s going to be a bad situation.”
The exact consequences of a repeat flirtation with breaking the debt ceiling are impossible to estimate with any precision. But officials in the US think they would be serious.
Speaking at a press conference this week, Fed chair Jay Powell underscored that failing to raise the limit would pitch the US economy into “unchartered territory”. The consequences were not only very uncertain but also “could be quite high”.
“We shouldn’t even be talking about a world in which the US doesn’t pay its bills. It shouldn’t be a thing,” he added. “No one should assume that the Fed can protect the economy and financial system and our reputation from the damage that such an event might inflict.”
In 2011, the US Treasury had a plan to ensure that the government did not default on its obligations to Treasury bondholders by cutting spending. But this implies huge cuts, which could send the US economy into recession and weigh on global growth.
According to the White House’s Council of Economic Advisers, a protracted US default “would likely lead to severe damage to the economy, with job growth swinging from its current pace of robust gains to losses numbering in the millions”. They forecast an “immediate, sharp recession” with the intensity of the downturn seen during the global financial crisis more than a decade ago.
Even a default that is corrected quickly could prompt a sharp drop in growth. Economists from Moody’s warn that 2mn jobs could be lost under such a scenario.
Economists at the Brookings Institution, a Washington think-tank, cautioned in a recent report that even a shortlived impasse would lead to “sustained — and completely avoidable — damage”. Wendy Edelberg and Louise Sheiner, the authors, said the extent of the damage depended in large part on how the government chose to prioritise its payments — something that would inevitably result in legal challenges.
El-Erian said the financial effects of a default on debt were “potentially bigger” than delaying other government payments, but even in the latter scenario, “there would be concern about the potential economic spillovers”.
With so much at stake, analysts have begun to pepper notes to clients with warnings.
Evan Brown and Luke Kawa, at Swiss lender UBS, said any default on US debt would constitute a “major financial crisis” and would therefore be unlikely because the Treasury would prioritise honouring its obligations. Ironically, a downturn in growth could boost US government bond prices as it would lead markets to price in more interest rate cuts from the Fed later this year.
Bank of America analysts have said, while reports of the replacement of the dominant role of the greenback in global transactions were “greatly exaggerated”, defaults from a debt ceiling showdown “would compromise the dollar’s attractiveness as a store of value”.