What will happen to the U.S. economy if Congress fails to raise the debt ceiling?

In this article, we look at the economic fallout if the U.S. fails to raise the debt ceiling.

The U.S. government officially reached its USD 31.4 trillion borrowing limit on 19 January, although a series of “extraordinary measures” should allow the administration to muddle through until at least June before borrowing constraints bite. For now, financial markets are sanguine; the S&P 500 stock market index is up so far this year, and 10-year Treasury yields have been broadly stable. The U.S. has never intentionally defaulted on its debt, and historical standoffs over the debt limit have always resulted in either the Republicans or the Democrats blinking eventually.

However, the risk of a prolonged Congressional stalemate appears higher this time due to the polarized political landscape. Republican House Speaker McCarthy was himself only elected to the post after 15 ballots among members of his party, and promised harsh public spending cuts in order to secure the support of far-right Republicans; the Democrats flatly reject such cuts.

If no agreement is reached to raise the debt ceiling, the government will be forced to cut spending to match revenue once the Treasury’s “extraordinary measures” run their course. With the Consensus among our panelists for a 2023 fiscal deficit of nearly 5% of GDP, this would pull a vast amount of public expenditure from the economy virtually overnight. A combination of furloughing, deep Federal spending cuts, a public debt default, credit rating downgrades, stock market falls and higher interest rates would likely ensue, with the impact magnified the longer the debt ceiling dispute remains unresolved.?

There are steps the authorities could take to mitigate the damage. The government could attempt to prioritize certain expenditure, such as making bond payments at the cost of slashing departmental spending in an attempt to calm financial markets. There has also been talk of the government depositing a newly-minted coin with the Fed in exchange for cash, or swapping outstanding bonds for new “premium” ones with a far higher interest rate. And the Federal Reserve would surely intervene in some form or other; in the past, Fed officials have floated the possibility of buying defaulted Treasury bonds while selling unaffected ones for instance.

However, none of the Treasury’s options would completely avert the fallout from the debt ceiling binding, and the Fed would be loath to bail out the government due to concerns over inflation and political independence. As such, for now, the economy’s best hope of emerging unscathed is that the severe consequences of default eventually focus politicians’ minds—before it is too late.

Insights from Our Analyst Network

On the outlook,?the EIU?said:

“We ultimately expect a deal to be reached to raise the debt ceiling, given the severe consequences of a US debt default. A last-minute compromise remains the most likely scenario, given the depth of partisan tensions in Congress. As a result, brinksmanship over the debt ceiling will increase economic uncertainty in the coming months and distract lawmakers, weakening government effectiveness.”

On Fed intervention,?ING analysts?said:

“Federal Reserve printing could be employed as a safety net […], where politics makes a mistake, and the Fed steps in as a payer of last resort. The Fed could rationalise doing so as a means of protecting the system. It could certainly soften the impact and indeed could prevent a technical default in the first place. However, this would not be a structural solution. Moreover, it poses its own independent threat to the financial system as the US dollar is undermined by monetary financing of the national debt.”