Economists are increasingly concerned that the US will generate fresh turmoil in the coming weeks as it hits the debt ceiling and is unable to pay all its bills.
With the two major political parties unable to agree on an increase to the $31.4 trillion ceiling on US federal debt, Treasury Secretary Janet Yellen has warned that stopgap measures to circumvent the limit will go astray. as soon as June 1st.
At that point, the US federal government would be faced with various unpalatable options, ranging from delaying payments to contractors, Social Security recipients, providers or Medicare agencies; to payment defaults in the United States government debt. It could also carry out spending programs in defiance of the ceiling.
In each of these scenarios, analysts believe a political, financial and economic crisis would be difficult to avoid.
While the disputes in Congress are the most serious in at least a decade, Mohamed El-Erian, president of the University of Cambridge’s Queens’ College, said the expectation was still that a last-minute deal would be reached between Democrats and Republicans. If that fails, “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 eager to contain banking tremors in 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 people have.” There’s been a “kind of multiplier effect with the debt ceiling, where people are a little bit more nervous and they’re a little bit more nervous about this kind of systemic risk.”
The last time the US was this close to reaching its debt ceiling was in 2011. Although a deal was eventually reached, four days later Standard & Poor’s, the credit rating agency, removed the AAA rating from US government debt. The downgrade sent US stock prices down more than 5% in one 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 is now stronger. However, hitting the debt ceiling would still be a destabilizing blow. “If you have the 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 looks a little different [than 2011]it will be a bad situation.
The exact consequences of repeated flirting with the breakup of the debt ceiling are impossible to estimate accurately. But officials in the US think they would be serious.
Speaking at a press conference this week, Fed Chairman Jay Powell stressed that failure to raise the limit would plunge the US economy into “uncharted territory.” The consequences were not only very uncertain but also “could be quite high”.
“We shouldn’t even be talking about a world where the United States doesn’t pay the bills. It shouldn’t be a thing,” she added. “No one should assume that the Fed can protect the economy and financial system and our reputation from the damage such an event could inflict.”
In 2011, the US Treasury had a plan to ensure the government did not default on its obligations to Treasury bondholders by cutting spending. But that implies huge cuts, which could send the US economy into a recession and weigh on global growth.
According to the White House’s Council of Economic Advisers, a sustained US default “would likely do serious damage to the economy, with job growth swinging from the current pace of strong gains to losses in the millions.” They predict an “immediate and acute recession” with the intensity of the recession seen during the global financial crisis more than a decade ago.
Even a default that is quickly corrected could lead to a sharp drop in growth. Moody’s economists warn that 2 million jobs could be lost in such a scenario.
Economists at the Brookings Institution, a Washington think tank, cautioned in a recent report that even a short-lived impasse would lead to “prolonged and completely avoidable damage.” Wendy Edelberg and Louise Sheiner, the authors, said the extent of the damage depended largely on how the government chose to prioritize its payments, which would inevitably have resulted in lawsuits.
El-Erian said the financial effects of a debt default are “potentially greater” than delaying other government payments, but even in the latter scenario “there would be concerns about the potential economic fallout.”
With the stakes so high, analysts have begun peppering notes to clients with caveats.
Evan Brown and Luke Kawa, of Swiss lender UBS, said any default on US debt would constitute a “major financial crisis” and would therefore be unlikely because the Treasury would prioritize meeting its obligations. Ironically, a slowdown in growth could drive US treasury prices higher as it would lead markets to price in further interest rate cuts by the Fed later this year.
Bank of America analysts said that while reports of the replacement of the greenback’s dominant role in global transactions were “greatly exaggerated,” defaults resulting from a debt ceiling showdown “would undermine the dollar’s attractiveness as a store of value”.
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