The US standard prospectus is hurting the economy in the meantime

As debt ceiling negotiations continue in Washington and the date when the US government could be forced to stop paying some bills nears, everyone involved has warned that such a default would have catastrophic consequences.

But a default may not be necessary to hurt the US economy.

Even if an agreement is reached before the last minute, the long uncertainty could increase borrowing costs and further destabilize already unstable financial markets. It could lead to a pullback in investment and business hiring when the US economy already faces increased risk of a recession, and hinder the financing of public construction projects.

More generally, the gap could reduce long-term confidence in the stability of the US financial system, with lasting consequences.

At the moment, investors are showing few signs of alarm. Although markets fell on Friday after Republican leaders in Congress declared a “pause” in negotiations, the declines were modest, suggesting that traders are betting that the parties will reach an agreement eventually – as they always have before.

But investor sentiment can shift rapidly as the so-called X-date, when the Treasury can no longer continue to pay the government’s bills, approaches. Treasury Secretary Janet L. Yellen has said the date could come as early as June 1. One thing that’s already happening: As investors worry that the federal government will default on soon-to-maturity government bonds, they’ve started demanding higher interest rates. compensation for greater risk.

If investors lose faith that leaders in Washington will resolve the conflict, they could panic, said Robert Almeida, a global investment strategist at MFS Investment Management.

“Now as the stimulus wears off, the growth wears off, you start seeing all these little mini-fires,” Mr. Almeida said. “It makes what is already a difficult situation more stressful. When the herd moves, it tends to move very quickly and violently.”

That’s what happened during a debt-ceiling standoff in 2011. Analysis after the near-default showed that the falling stock market evaporated $2.4 trillion in household wealth, which took time to rebuild and cost taxpayers billions in higher interest payments. Today, credit is more expensive, the banking sector is already shaken and an economic expansion is slowing down rather than starting.

“2011 was a very different situation — we were recovering from the global financial crisis,” said Randall S. Kroszner, an economist at the University of Chicago and former Federal Reserve official. “In today’s situation, where there is a lot of fragility in the banking system, you take more risk. You pile fragility on fragility.”

The mounting voltage can cause problems through a number of channels.

Rising interest rates on federal bonds will filter into interest rates on car loans, mortgages and credit cards. That hurts consumers, who have started accumulating more debt — and taking longer to pay it back — as inflation has pushed up the cost of living. Increasingly urgent headlines could cause consumers to pull back on their purchases, which drive about 70 percent of the economy.

Although consumer sentiment is darkening, it can be attributed to a number of factors, including the recent failure of three regional banks. And so far it doesn’t appear to be spilling over into spending, said Nancy Vanden Houten, senior economist for Oxford Economics.

“I think all of that could change,” Vanden Houten said, “if we get too close to the X date and there’s real fear of missed payments for things like Social Security or interest on the debt.”

Suddenly higher interest rates would pose an even bigger problem for heavily indebted companies. If they have to roll over loans that are due soon, making it 7 percent instead of 4 percent could throw off their profit forecasts, leading to a rush to sell shares. A widespread decline in share prices will further weaken consumer confidence.

Even if markets remain calm, higher borrowing costs drain public resources. An analysis by the Government Accountability Office estimated that the 2011 debt limit increased the Treasury’s borrowing costs by $1.3 billion in fiscal year 2011 alone. At the time, the federal debt was about 95 percent of the nation’s gross domestic product. Now it is 120 percent, which means that it can be much more expensive to service the debt.

“It will ultimately crowd out resources that could be spent on other high-priority government investments,” said Rachel Snyderman, a senior associate director at the Bipartisan Policy Center, a Washington think tank. “That’s where we see the cost of brinkmanship.”

Disrupting the smooth functioning of federal institutions has already created a headache for state and local governments. Many are issuing bonds using a US financial mechanism known as the “Slugs window”, which closed on May 2 and will not reopen until the debt limit is raised. Public enterprises that often collect money in this way now have to wait, which can hold back large infrastructure projects if the process drags on longer.

There are also more subtle effects that can last longer than the current confrontation. The US has the lowest borrowing costs in the world because governments and other institutions prefer to hold their wealth in dollars and government bonds, the one financial instrument that is believed to carry no risk of default. Over time, these reserves have begun to shift into other currencies – which can eventually make another country the preferred port of call for large reserves of cash.

“If you’re a central banker and you look at this, and this is kind of a recurring drama, you can say ‘we love our dollars, but maybe it’s time to start holding more euros,'” Marcus Noland said. executive director at the Peterson Institute for International Economics. “The way I would describe that ‘Perils of Pauline’, short-of-standard scenario, is that it just adds an extra push to that process.”

When do these consequences actually start to increase? In a sense, only when investors shift from assuming a deal at the last minute to anticipating a default, a time that is nebulous and impossible to predict. But a credit rating agency can also make that decision for everyone else, as Standard & Poor’s did in 2011 — even after a deal was reached and the debt limit was raised — when it downgraded the U.S. debt to AA+ from AAA, sending stocks tumbling.

This decision was based on the political resentment surrounding the negotiations, as well as the size of the federal debt – both of which have increased in the intervening decade.

It is not clear exactly what would happen if the X-date went without an agreement. Most experts say the Treasury Department will continue paying interest on the debt and instead delay meeting other obligations, such as payments to government contractors, veterans or doctors who treat Medicaid patients.

That would prevent the government from immediately defaulting on its debt, but it could also shatter confidence, knock financial markets and lead to a sharp decline in hiring, investment and spending.

“These are all standards, just defaults to different groups,” said William G. Gale, an economist at the Brookings Institution. “If they can do it to veterans or Medicaid doctors, eventually they can do it to bondholders.”

Republicans have proposed combining a debt limit increase with sharp cuts in public spending. They have promised to spare Social Security recipients, Pentagon spending and veterans benefits. But that equation would require sharp cuts in other programs — like housing, toxic waste cleanup, air traffic control, cancer research and other categories that are economically important.

The Budget Control Act of 2011, which resulted from that year’s shutdown, ushered in a decade of caps that progressives have criticized as preventing the federal government from responding to new needs and crises.

The economic turbulence from the debt ceiling comes as Federal Reserve policymakers try to tame inflation without causing a recession, a delicate task with little margin for error.

“The Fed is trying to thread a very fine needle,” said Kroszner, the former Fed economist. “At some point you break the camel’s back. Will this be sufficient to do so? Probably not, but do you really want to take that risk?”