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Up Front

How worried should we be if the debt ceiling isn’t lifted?

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The debt limit caps the total amount of allowable outstanding U.S. federal debt. The U.S. hit that limit on August 1, 2021, but the Department of the Treasury has been undertaking a set of “extraordinary measures” so that the debt limit does not yet bind. The Treasury estimates that by October 18th, those measures will not be sufficient—unless Congress raises or suspends the debt limit before then, the Federal government will lack the cash to pay all its obligations.

The economic effects of such an unprecedented event would surely be negative. However, there is an enormous amount of uncertainty surrounding the speed and magnitude of the damage the U.S. economy will incur if the U.S. government is unable to pay all its bills for a time—it depends on how long the situation lasts, how it is managed, and the extent to which investors alter their views about the safety of U.S. Treasuries. An extended impasse is likely to cause significant damage to the U.S. economy. Even in a best-case scenario where the impasse is short lived, the economy is likely to suffer sustained—and completely avoidable—damage, particularly given the challenges that COVID-19 poses to the health of the economy.

The U.S. government pays a lower interest rate on Treasury securities because of the unparalleled safety and liquidity of the Treasury market. Some estimates suggest that this advantage lowers the interest rate the government pays on Treasuries (relative to interest rates on the debt of other sovereign nations) by something on the order of 25 basis points (a quarter of a percentage point) on average. Given the current level of the debt, this translates into interest savings for the federal government of roughly $60 billion this year, and over $700 billion over the next decade. Even if only some of this advantage were lost by allowing the debt limit to bind, the cost to the taxpayer could be significant.

How will the U.S. Treasury operate when the debt limit binds?

One cannot predict how Treasury will operate when the debt limit binds, given that this would be unprecedented. Treasury did have a contingency plan in place in 2011 when the country faced a similar situation, and it seems likely that Treasury would follow the contours of that plan if the debt limit binds this year. Under the plan, there would be no default on Treasury securities. Treasury would continue to pay interest on those Treasury securities as it comes due. And, as securities mature, Treasury would pay that principal by auctioning new securities for the same amount (and thus not increasing the overall stock of debt held by the public). Treasury would delay payments for all other obligations, such as payments to agencies, contractors, Social Security beneficiaries, and Medicare providers, until it had at least enough cash to pay a full day’s obligations, rather than attempting to pick and choose which payments to make that are due on a given day.

Timely payments of interest and principal of Treasury securities alongside delays in other federal obligations would likely result in legal challenges. On the one hand, the motivation to pay principal and interest on time to avoid a default on Treasury securities is clear; on the other, lawsuits would probably argue that holders of Treasury securities have no legal standing to be paid before others. It is not clear how such litigation would turn out, in part because the law itself imposes contradictory requirements on the government—requiring it to make payments, honor the debt, and not go above the debt limit, three things that cannot all happen at once.

How much would non-interest federal spending have to be cut?

If the debt limit binds, and the Treasury were to make interest payments, then other outlays will have to be cut by about 40 percent in aggregate. The need for the sharp cut reflects two factors. First, the government is running annual deficits: for fiscal year 2022 as a whole, CBO expects 22 cents of every dollar of non-interest outlays to be financed by borrowing. Second, infusions of cash to the Treasury from tax revenues vary greatly by month, and tax revenues in October and November tend to be fairly muted. Thus, the required cuts to federal spending when an increase in federal debt is precluded are particularly large during these months. If Treasury wanted to be certain that it always had sufficient cash on hand to cover all interest payments, it might need to cut non-interest spending by more than 40 percent.

How would a binding debt limit affect the economy?

The extent of the economic costs of the debt limit binding, while assuredly negative, are enormously uncertain. Assuming interest and principal is paid on time, the very short-term effects largely depend on the expectations of financial market participants, businesses, and households. Would the stock market tumble precipitously the first day that a Social Security payment is delayed? Would the U.S. Treasury market, the world’s most important, function smoothly? Would there be a run on money market funds that hold short-term U.S. Treasuries? What actions would the Federal Reserve take to stabilize financial markets and the economy more broadly?

Much depends on whether investors would be confident that Treasury would continue paying interest on time and on how long they think the impasse will persist. If people expect the impasse will be short lived and are certain that the Treasury will not default on Treasury securities, it is possible that the initial response could be muted.

However, even if the debt limit were raised quickly so that it only was binding for a few days, there would likely be lasting damage. At the very least, financial markets would likely anticipate such disruptions as we approached the debt limit in the future. In addition, the shock to financial markets and loss of business and household confidence could take time to abate.

If the impasse were to drag on, market conditions would likely worsen with each passing day. Concerns about a default would grow with mounting legal and political pressures as Treasury security holders were prioritized above others to whom the federal government had obligations. Concerns would grow regarding the possibility of a recession triggered by a protracted sharp cut in federal spending.

Worsening expectations regarding a possible default would make significant disruptions in financial markets increasingly likely. That could result in an increase in interest rates on newly issued Treasuries. If financial markets started to pull back from U.S. Treasuries all together, the Treasury could have a difficult time finding buyers when it sought to roll over maturing debt, perhaps putting pressure on the Federal Reserve to purchase additional Treasuries in the secondary market. Such financial market disruptions would very likely be coupled with declines in the price of equities, a loss of consumer and business confidence, and a contraction in access to private credit markets.

Financial markets, businesses, and households would become more pessimistic about a quick resolution and increasingly worried that a recession was inevitable. More and more people would feel economic pain because of delayed payments. Take just a few examples: Social Security beneficiaries seeing delays in their payments could face trouble with obligations such as rent and utilities; federal, state, and local agencies implementing urgent pandemic-related work might see delays in payments that interrupted their work; federal contractors and employees would face uncertainty about how long their payments would be delayed. Those and other disruptions would have enormous economic and health consequences over time, and ultimately the cuts to federal spending would cause a deep recession. That recession would be particularly painful in the midst of the pandemic. Moreover, tax revenues, the only resource the Treasury would have to pay interest on the debt, would be dampened, and the federal government would have to cut back on non-interest outlays with increasing severity.

In a worst-case scenario, at some point Treasury would be forced to delay a payment of interest or principal on U.S. debt. Such an outright default on Treasury securities would very likely result in severe disruption to the Treasury securities market with acute spillovers to other financial markets and to the cost and availability of credit to households and businesses. Those developments could undermine the reputation of the Treasury market as the safest and most liquid in the world.

Estimates of the effects of a binding debt limit on the U.S. economy

It is obviously difficult to quantify the effects of a binding debt limit on the macroeconomy. However, history and illustrative scenarios provide some guidance.

Evidence from prior “near-misses”:

As discussed in this Hutchins Center Explains post, when Congress waited until the last minute to raise the debt ceiling in 2013, rates rose on Treasury securities scheduled to mature near the projected date the debt limit was projected to bind—by between 21 basis points and 46 basis points, according to an estimate from Federal Reserve economists, and liquidity in the Treasury securities market contracted. Yields across all maturities also increased a bit as well, according to this study–by between 4 basis points and 8 basis points—reflecting investors’ fears of broader financial contagion. Similarly, after policymakers came close to the brink of the debt limit binding in 2011, the GAO estimated that the delays in raising the debt limit increased Treasury’s borrowing costs by about $1.3 billion that year. The fact that the estimated effects are small in comparison to the U.S. economy likely reflects that investors didn’t think it very likely that the debt ceiling would actually bind and, if it did, thought that the impasse would be very short lived.

Evidence from macroeconomic models:

In October 2013, the Federal Reserve simulated the effects of a binding debt ceiling that lasted one month—from mid-October to mid-November 2013—during which time Treasury would continue to make all interest payments. The Fed economists estimated that such an impasse would lead to an 80 basis point increase in 10-year Treasury yields, a 30 percent decline in stock prices, a 10 percent drop in the value of the dollar, and a hit to household and business confidence, with these effects waning over a two-year period. According to their analysis, this deterioration in financial conditions would result in a mild two-quarter recession, leading to an increase in the unemployment rate of 1.25 percentage points and 1.7 percentage points over the following two years. Such an increase in the unemployment rate today would mean the loss of 2 million jobs in 2022 and 2.7 million jobs in 2023.

Macroeconomic Advisers conducted a similar exercise in 2013. It assessed the economic costs of two scenarios – one in which the impasse lasted just a short time and another in which it persisted for two months. Even in the scenario in which the impasse was resolved quickly, the economic consequences were substantial—a mild recession and a loss of 2.5 million jobs that returned only very slowly. For the two-month impasse, which included a deep cut to federal spending in one quarter, offset by a surge in spending in the next quarter, the effects were larger and longer lasting. In the analysis, such a scenario would lead to the near-term loss of up to 3.1 million jobs. Even two years after the crisis, jobs would remain 2.5 million lower than they otherwise would have been.

In a very recent analysis, Moody’s Analytics concluded that the costs to the U.S. economy of allowing the debt limit to bind now would be even higher. In Moody’s simulation, if the impasse lasted through November, employment would decline by 5 million and real GDP would decline almost 4 percent in the near term before recovering over the next few quarters.

Conclusion

While subject to great uncertainty, those analyses demonstrate that the effects of allowing the debt limit to bind could be quite severe, even if, as is assumed, principal and interest payments continued to be made. If instead the Treasury failed to fully pay all principal and interest payments—because of political or legal constraints, unexpected cash shortfalls, or a failed auction of new Treasury securities—the consequences would be even more dire.


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