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What to Expect if the U.S. Defaults

What to Expect if the U.S. Defaults

By Michael Madowitz - October 10, 2013

The effects of a U.S. government debt default will largely depend on how soon the House of Representatives ends its fiscal brinksmanship. As the 2011 debt-ceiling standoff showed, the effects of a potential default will not wait until the Treasury deadline of October 17, and the 2008 financial crisis proved it is extremely difficult to predict what will break in the financial system until it has broken.

With that in mind, this issue brief examines two basic scenarios of a U.S. default: one in which the debt ceiling results in a default for only a short time—say, less than one business day—and one in which the United States is unable to borrow for a longer period.

In either case, a failure to lift the debt ceiling in a timely manner will result in:

  • Significantly increased interest costs on the national debt
  • Long-term negative impacts for the U.S. economy
  • Real, tangible, and costly consequences for everyday Americans
  • Severe, unpredictable consequences for the U.S. and the world financial system
  • Macroeconomic consequences that increase with each day the debt ceiling restrains activity
  • An immense amount of unpredictable downside risk to the U.S. economy

It is difficult to overstate the amount of risk involved in failing to raise the debt ceiling—not because it is challenging to estimate the cost of each individual consequence, but because it is so difficult to conceive all of the relevant consequences. Due to the vast uncertainty about possible outcomes, this issue brief likely understates the nature of the risks involved.

The known risks to the economy

There is no ambiguity about whether failing to raise the debt ceiling will harm the U.S. economy. What is ambiguous is how much harm will be done. The 2011 debt-ceiling standoff offers some insight. At that time, Federal Reserve Chairman Ben Bernanke testified before Congress about the consequences of failing to raise the debt ceiling, saying, “It would be extremely dangerous and likely [a] recovery-ending event.”

The simplest cost to the economy to pin down is how much long-term interest-rate increases will cost taxpayers directly. Like all bonds, U.S. Treasury-issued debt, or Treasuries, have interest rates that reflect a risk premium. The risk premium on Treasuries is currently very close to zero, which means the interest costs of our national debt are quite low, despite the fact that publicly held debt is just under $12 trillion. Although mocked for the lack of market response at the time, the Standard and Poor’s downgrade of the U.S. credit rating in August 2011 appears prescient now. S&P stated that “the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened.” An increase in the interest premium paid on the federal debt currently held by the public would cost taxpayers a lot—an increase between 0.1 percentage points and 0.5 percentage points would cost taxpayers between $120 billion and $600 billion over the next 10 years.

As a recent Treasury report noted, there are some direct parallels to the 2011 debt-ceiling standoff that serve as a baseline of comparison for some of the costs of simply approaching the precipice. If we assume that the current standoff is resolved in a similar manner as the last one—specifically, at the last minute, but before any defaults occur—the U.S. economy would still incur a host of negative consequences. The Treasury report notes that the S&P 500 Index declined roughly 17 percent in the period surrounding the 2011 episode, and in the same financial quarter, household wealth fell by $2.4 trillion and retirement assets fell by $800 billion; it took six months to return to pre-crisis levels after not quite hitting the debt ceiling. Unsurprisingly, the effects on consumer and business confidence were also strongly negative and took months to return to their pre-crisis levels.

If the current deadline is not met, similar, presumably larger effects can be expected. However, a number of complications make pinning down an exact cost difficult. While wealthier Americans will primarily be affected by changes in asset prices, all Americans will be affected by the ripple effects in credit markets. Virtually every kind of credit used by middle-class Americans—from credit cards to student, auto, and home loans—is connected to interest rates on Treasuries. Typically, the issuers of these credit products make their profits by charging an additional interest spread on top of Treasury rates, so an increase in the interest rate on Treasuries alone will drive up borrowing costs.

During the last episode, the spread on home loans significantly increased after the standoff, with 30-year fixed rates jumping by almost 0.75 percent—about $100 per month—for a typical mortgage on a median-priced home. Not only would a similar event slow the pace of refinances and purchases, but if the risk premium on U.S. bonds increases, Americans with adjustable-rate mortgages would also see the payments rise on their existing mortgages.

Increased credit costs would have a significant direct effect on the recovery, even in the case of a very short-term default. As investors demand a larger risk premium on Treasuries, this cost will be passed through to financing costs in the housing and auto sectors. After struggling over the past few years, these sectors have recently regained steam and have begun to lead the recovery. Due in part to favorable lending conditions and pent-up demand, auto sales are on pace for their best year since 2007.

The housing market—which often leads economic recoveries—has been extremely slow to respond to this downturn, in large part because it led the downturn. Fortunately, the market has markedly improved over the last year, but the housing recovery is very fragile. If there is a delay in lifting the debt ceiling, the best-case scenario for the housing market is not pretty. The additional risk premium generated by a default on Treasury bonds would be passed onto consumers in the form of higher interest rates, and the experience from the last standoff suggests fixed rates would increase by an even larger amount. Higher rates slow the pace of homebuying and, coupled with recent increases in interest rates, would have a chilling effect on the refinances that have been one of the major channels of monetary stimulus throughout the recovery.

None of these costs are trivial, especially at this fragile moment in the economic recovery. Default will carry long-lived increases in the risk premium paid on Treasury bonds, which filter through to every type of borrowing and banking done by Main Street America. Increased volatility in asset prices and decreases in consumer and business confidence as well as household wealth are harmful to an economy at any point; given the current state of the recovery, even these consequences—which are the least severe and most easily understood ones of a temporary default—will impose real, significant costs on average Americans.

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This article is reprinted with permission from the Center for American Progress

Michael Madowitz

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