What Happens If the US Defaults on the Debt Ceiling?
Recent analyses from the Congressional Budget Office and independent researchers indicate that an actual breach of the debt ceiling would severely damage the economy. If such an event were to happen, Treasury may seek ways to avoid default by prioritizing interest payments but any such move may face legal challenges from those demanding that federal agencies fulfill all their obligations.
What would happen||US Defaults on the Debt Ceiling
The debt ceiling refers to a limit on how much federal government debt the US can issue at one time, which serves as a key limiting factor when paying our bills. If we breach this limit, interest payments on past debt might go unpaid which would lead to default and have negative repercussions for financial markets and the economy as a whole.
However, we’ve never actually defaulted on our debt before – Congress was always able to raise or extend the debt limit before it reached a critical threshold. Additionally, the US has never experienced a downgrade to its credit rating which stands as testament to our strong economy and financial system.
But that doesn’t rule out default entirely. Should this political standoff drag on and we breach the debt ceiling, then Treasury may use “extraordinary measures” – accounting tricks – to continue paying its bills until money runs out for good.
Treasury could get around this by creating new securities that don’t strictly qualify as bonds and selling these to investors to raise funds for government expenditures. Unfortunately, investors might find it hard to trust these new securities over time and could lead to their ineffectiveness as a way of raising funds for government expenses.
Another way the Treasury could avoid default is by cutting spending elsewhere – but this would violate Congress’ constitutional authority to set spending levels, and be bad for many reasons: such cuts would harm an already fragile US economy further and could trigger recession that harms Americans and their families.
Due to these considerations, Congress and President Obama should come together quickly in reaching an agreement and avoiding default. Even so, any agreement reached may cause short-term damage to financial markets and the economy – something which may take time to heal over time. As investors should remain focused on long-term planning rather than daily headlines.
What would happen to the economy?
Debt ceilings are technical limits on how much the US Treasury can borrow to pay for spending bills passed by Congress. When this limit is reached, new bonds cannot be sold to pay off existing debt, effectively leading to US default – something we are witnessing with Congress’ heated fight over spending and taxes leading up to this point.
An attempt at breaching the debt ceiling would cause immediate chaos on financial markets where trillions of dollars of Treasury debt is traded daily; money market funds that hold short-term Treasuries would experience sudden outflows as investors demanded greater rewards in return for risk taking.
Treasury may be forced to prioritize certain obligations over others, for instance paying interest on past debt while delaying Social Security checks and paychecks for federal employees, though such an action would likely face legal challenge quickly, while failing to prevent long-term economic costs as discussed above.
Long term, an extended debt ceiling standoff would erode household confidence and restrict investment and consumption. Moody’s Analytics estimates that under a scenario whereby the federal government defaulted for multiple quarters, GDP would contract by about 4% while stocks fell roughly 25%, retirement accounts took a hit and unemployment rose five percentage points as businesses reduced hiring while households reduced spending.
Longer term default could also see the Treasury’s creditworthiness reduced, making it harder for households and businesses to borrow funds on private markets – pushing interest rates higher and making mortgages and car loans more costly; as well as redirecting federal investments away from infrastructure, education, and health care investments – which economists agree would have devastating repercussions for economic wellbeing. Most economists view any US default as bad news as this could send shockwaves around the globe as well as have devastating ramifications on economic wellbeing.
What would happen to the dollar?
Since 2011, lawmakers have sparred over raising the debt ceiling, with budget hawks demanding spending cuts in exchange for any increase. This tussle has led to disruption and raised fears of default; “if a deal cannot be reached and Treasury runs out of funds, that would cause panic among investors who will flee into safe-haven assets such as money market funds or bonds from top companies,” warns Mark Zandi of Moody’s Analytics. “Investors would move toward safe haven assets like U.S. money market funds or bonds from top-flight companies as investors seek refuge among safe haven assets – in case panic ensues
Under a default scenario, the United States would be forced to prioritize payments in a very difficult manner – possibly including choosing between paying interest on debt owed to it and other bills like paying federal workers and military retirees. “Such an event would have an enormous negative effect on the economy,” Zandi noted, noting it “is simply not acceptable”.
The government could attempt to stave off default with temporary measures like suspending some employee savings programs and delaying auctions of securities, but such steps might only postpone crisis for months. As former assistant Treasury secretary Robert Lowery pointed out, in such an event the United States might need to decide “how much is paid out in benefits and salaries – an ethically dubious decision,” meaning stopping Social Security checks and Medicare benefits payment as well as interest on debt payments could risk credit downgrade.
Failure to raise the debt limit would damage the dollar’s global standing and its global demand, which has long been driven by creditworthiness of Treasury securities and their global demand. Such a default could hit emerging economies which hold large quantities of their foreign reserves in Treasurys – this may prompt China to divert some holdings away from treasuries and into other currencies, further diminishing demand for them and hence further destabilize demand for dollars and their value.
What would happen to the bond market?
Basic economic principles suggest that the federal government should never stop making its payments, which could disrupt financial markets in unpredictable ways. If investors stop purchasing Treasuries altogether, Treasury might find it harder to find buyers when needing to roll over maturing debt and issue new bonds – leading to higher interest rates charged to banks for borrowing money from them.
However, the impact on the economy could be much more profound if the impasse in Washington were to persist for extended periods. That’s because people’s expectations of default could cause their willingness to lend to the federal government to decline; leading them to demand higher interest rates in exchange for the risk they assume – raising costs for homebuying or opening credit card accounts in turn.
At its core, a default would actually reduce how much federal spending can go toward education, health care and infrastructure projects – not only within America itself; people reliant on exports or investments from America could feel its effects worldwide as confidence in its debtworthiness is crucial to its status as a reserve currency and any reduction would cause ripple effects around the globe.
As it stands, Americans are still trying to understand how a default would impact them. Bills due on June 3 could go unpaid if the government does not raise its debt limit by then; this could affect millions of retirees, veterans, and families who depend on Social Security or veterans benefits, not to mention companies exporting to the U.S. If that occurs, more orders could stop coming in altogether, making Congress and President Obama urgently required to work out a solution quickly. Read more>