Last-minute debt ceiling deal could still trigger recession
An agreement in the coming days to raise the nation’s debt limit will not necessarily sound like a clear signal for the American economy.
Sure, it would avert the “economic and financial disaster” envisioned by Treasury Secretary Janet Yellen. The doomsday scenario shows global financial markets in turmoil, mortgage rates rising, seniors missing Social Security checks and millions of jobs wiped out.
But an 11th-hour deal that limits defaults but frays nerves, sinks stocks and pushes up interest rates could still do some damage, like similar conflicts in 201[ads1]1 and 2013, and even push a fragile economy into recession. That is far more likely than a breach of the debt limit triggering economic disaster.
“The economy is already very fragile and on the edge of recession,” said Mark Zandi, chief economist at Moody’s Analytics, who is among the minority of economists who predict the US will avoid a downturn this year.
In the event of a nail-biting deal that leaves already volatile markets, a downturn is “very possible,” Zandi says.
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What is the debt ceiling?
The debt ceiling is the cap on how much money the government can borrow to pay for everything from Medicare benefits and military pay to payments it owes bondholders for past debts. An agreement and vote to approve it does not promise any additional spending. It only increases the amount the government can borrow to pay for obligations already passed by Congress.
If the cap is not raised, the government will have to struggle to pay bills with only the revenue it brings in from taxes. That would force the Biden administration to decide whether to pay recipients of Social Security and federal employees or bondholders who have loaned money to the government.
A default would occur if the US fails to repay bondholders, but failing to fund other government spending would still hurt the economy.
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Yellen has said the government could run out of money to pay its bills as early as June 1 if Congress does not increase the nation’s borrowing authority, giving President Joe Biden and Republican lawmakers just over two weeks to reach an agreement. Republicans are demanding sharp cuts in spending, but Biden says such budget talk should not be related to the debt ceiling.
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What happened to the debt ceiling in 2011 and 2013?
In 2011, Republicans similarly demanded that President Barack Obama agree to cut the deficit in return for raising the debt ceiling. An agreement was reached on July 31, just two days before the state’s borrowing authority was set to run out. Despite the agreement, the brinkmanship created uncertainty about the nation’s creditworthiness and prompted S&P Global Ratings to downgrade the US credit rating for the first time in history.
The S&P 500 index of stocks fell about 17% during the episode and did not recover until the following year, according to a financial report, reducing household wealth by $2.4 trillion. Consumer and business confidence plummeted and did not fully recover for several months, long after the agreement on the debt ceiling had been reached. Borrowing costs, for example for mortgages, rose. And consumer and business spending fell, says the financial report.
All told, the crisis caused a booming economy still recovering from the Great Recession of 2007-09 to shrink at an annualized rate of 0.16% in the third quarter, Zandi estimates. Without it, he reckons, the economy would have grown by 2.6%. The accident pushed unemployment up by 0.3 percentage points and reduced employment by 340,000 jobs, he calculates.
A similar conflict in the fall of 2013 also lurked, with Congress raising the debt ceiling a day before the October 17 deadline. In early October, with no deal in sight, the federal government partially shut down and hundreds of thousands of federal workers were laid off.
Zandi estimates that the crisis cut GDP growth in the fourth quarter of 2013 by half a percentage point, with about half the toll caused by the partial shutdown and the rest by a cloud of uncertainty that dampened consumer and business confidence and spending.
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How much can today’s debt ceiling drama damage the economy?
Even if an agreement is reached, the deadlock has created some uncertainty. Interest rates on short-term government bonds maturing after 1 June have risen. And the cost of credit default swaps – insurance in case the US defaults – has reached record highs. Equity markets have generally taken the conflict in stride, but have been more volatile in recent days as the deadline has approached.
Assuming the debt limit is not breached, the White House estimates that an eleventh-hour deal could still raise borrowing costs and hurt investment. It could:
- Cut third quarter GDP growth by 0.3 percentage points.
- Divide employment by 200,000 jobs.
Zandi agrees – if a pact is made by the end of next week. Under one possible scenario, the two sides could agree to raise the debt limit for a few months, then scramble to raise it again in September before the end of the fiscal year while negotiating the 2024 fiscal budget, Zandi says. That would allow Biden to say the debt ceiling and spending talks are separate. But postponing the conflict until late summer would mean continued uncertainty that could dampen the economy.
If the drama extends to within a day or two of the June 1 deadline, stocks could fall significantly and the financial fallout could look like 2011, Zandi predicts, meaning:
- GDP will be reduced by more than 2 percentage points.
- Employment would fall by a few hundred thousand jobs.
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How does cutting spending hurt the economy?
Oxford Economics also expects an agreement before the deadline to weaken the economy, but for a different reason. If Biden agrees to $2.4 trillion in spending cuts — a little more than half the amount that Republicans are demanding — it will turn a mild recession into a severe one, says Oxford economist Nancy Vanden Houten.
What would happen then?
- GDP will fall by 2.3 percentage points in the second half of the year instead of the 1.5 points Oxford has predicted.
- A further 460,000 jobs would be wiped out, says Oxford’s chief economist Ryan Sweet.
What happens if the debt ceiling is reached?
If Biden and GOP lawmakers fail to strike a deal by the deadline:
- Stocks are likely to crater.
- Interest rates will rise for mortgages, corporate bonds and other loans, Moody’s estimates.
In a short-term debt limit breach that causes Congress to resolve it within a week, here’s what will happen:
- GDP will fall by 0.7 percentage points from top to bottom.
- 1.5 million jobs would disappear.
- Unemployment will rise from 3.4% to almost 5%, Moody’s estimates.
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What if the debt ceiling drags on for weeks or months?
In a prolonged breach of the debt limit, “the blow to the economy would be catastrophic,” Moody’s says.
- The federal government will have to cut spending as funds run out and credit rating agencies downgrade the Treasury’s debt.
- Banks would be reluctant to lend, and households and businesses would scale back spending and investment.
- GDP will fall by 4.6 percentage points.
- Unemployment will increase to 8 percent.
- 7.8 million jobs will be lost, plunging the US into a deep recession, Moody’s estimates.
Even a decade from now, says the research firm, GDP would be almost a percentage point lower and there would be 1.2 million fewer jobs than if the crisis had not happened.
Contributor: Anna Kaufman