Impending US default threatens near-term economic downfall

Negotiations over the debt ceiling in Washington are ongoing, and the potential consequences of a US government default are alarming. However, some argue that a default may not result in the damage that is being touted. Even if a deal is reached at the last minute, prolonged uncertainty could still drive up borrowing costs and destabilize the already volatile financial markets. This could have severe implications for the US economy, hindering business investment and employment and setting back public works financing. More broadly, this conflict could also undermine long-term confidence in US stability.

Investors seem to be showing little caution at present, with any negative impacts likely to emerge as we approach the X-date for when the Treasury Department is unable to keep paying government bills. Treasury Secretary, Janet L. Yellen, has said that this date could be as early as June 1. Investors worried about the federal government defaulting on soon-to-maturity bonds are already starting to demand higher interest rates. If investors lost confidence that leaders in Washington would resolve their conflicts, it could cause a panic amongst investors and further damage. This happened during the 2011 debt ceiling stalemate, where $2.4 trillion of household wealth evaporated, costing taxpayers billions of dollars in high-interest payments.

If tensions continue to escalate, problems could arise through various channels—due to the increased cost of living, concern around rising interest rates could affect auto loans, mortgages, and credit card borrowing. This could lead to consumers taking on more debt, potentially stifling consumer confidence, which underpins around 70% of the US economy. The recent failures of three regional banks have contributed to consumers’ gloomy sentiment, but so far, it does not appear to be spilling over into spending.

If companies with substantial debt had to roll over maturing loans, their problems would be exacerbated by sudden interest rate hikes. This could further undermine consumer confidence, and rising borrowing costs would exhaust public resources, even if markets remained calm. The 2011 debt limit conflict increased the Treasury’s borrowing costs by $1.3 billion in fiscal 2011 alone, according to an analysis by the General Accounting Office when the federal debt stood at about 95% of gross domestic product. It is now at 120%, which means that debt service could be even more expensive. This could lock out money that could be used for other high-priority US government investments, resulting in the price of brinkmanship.

Hindering the smooth functioning of federal agencies is already a headache for state and local governments, with many of them issuing bonds using a US Treasury mechanism known as the “Slugs Window,” which ends on May 2 and will not resume until the debt ceiling is raised. This could stall large infrastructure projects, and the effects of the current conflict could linger beyond the immediate financial turmoil. Over time, the US may lose its status as the preferred port for large cash reserves, with investors opting to hold more euros.

The credit rating agencies may downgrade US government bonds from AAA to AA+ again, based on political animosity surrounding the negotiations and the sheer size of the federal debt. There is no clear indication of what will happen if X-dates pass by without trading at all. Most expect the Treasury to continue to make interest payments on debt, delaying other obligations, such as payments to government contractors, veterans, and doctors treating Medicaid patients. That would prevent the government from defaulting immediately, but experts warn these are still defaults, just different groups of defaults.

The 2011 debt limit conflict led to a decade-long financial crisis, and the cap has faced criticism from progressives who argue that it prevents the federal government from responding to new needs and crises. The economic turmoil from the current conflict comes at a time when Federal Reserve policymakers are trying to keep inflation under control without triggering a recession. It’s a delicate balancing act which may leave little margin for error.

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