What Happens if the Debt Ceiling Isn’t Raised?

While we expect Congress to raise the U.S. debt ceiling before the date on which the Treasury would run out of cash, there is a risk of inaction as that date approaches, which may have implications for the country’s AAA credit rating.

Looking at recent data on Treasury cash balances, there seems to be little time remaining to reach a deal. If Congress is late in raising the debt ceiling, the federal government will not be able to pay all its obligations.

We assume in this analysis that the polarized political atmosphere will delay an increase in the debt ceiling well into the summer months. If this proves to be the case, we believe the consequences for the U.S. economy and financial system would be highly negative, and significantly worse and longer-lasting if the Treasury misses any debt payments.

Key Highlights of the Debt-Ceiling Standoff

• If Congress fails to lift the debt ceiling before the “X-date”—when the Treasury will run out of cash—the federal government will not be able to pay all its obligations on time.
• Prioritizing debt-servicing payments could delay a default, but it would still have a negative effect on the U.S. economy and could quickly run into other challenges.
• If the Treasury misses a debt payment, the damage to the U.S. economy and financial system could be significantly greater and longer lasting.

Debt Prioritization Could Delay Default, but Would Still Hurt the Economy

If Congress fails to lift the debt ceiling, the Treasury may prioritize debt payments to avert an outright default. But this path is fraught with risks. In such a situation, outgoing Treasury payments would be constrained by the amount of tax revenue collected, leading to delays on noninterest expenditure.

To put the scale of the fiscal contraction in perspective, this would imply that all noninterest spending—including Social Security, Medicare/Medicaid, defense, and civil service salaries—would need to be cut by roughly 27%.

If the Treasury were to prioritize Social Security payments as well, then all other spending would need to be cut by 35%. Federal employees, including military personnel and many government contractors, could see their average monthly income fall by at least a fourth (that is, they’d miss at least one of every four biweekly paychecks) until the debt ceiling is raised. State governments would face shortfalls as well. Mid-June corporate tax receipts might limit the immediate buildup of arrears, but we would expect an entire month’s worth of arrears to accumulate in just over three months.

Combined with a reduction in consumer confidence, second-quarter growth is likely to be substantially weaker. The Federal Reserve Bank of Atlanta’s GDPNow forecast has second-quarter growth running at a 2.6% quarter-on-quarter seasonally adjusted annual rate. Average cutbacks to federal spending on the order of 27% for noninterest expenditures—particularly when combined with likely confidence and credit-tightening effects—would likely reduce second-quarter growth to less than zero, and we would expect negative growth in the third quarter, as well.

As in most recessions, discretionary spending would bear the brunt of the downturn, sharply reducing spending on consumer durables and services like restaurants and tourism. The confidence and wealth shocks would likely be powerful.

In the weeks surrounding the 2011 debt-ceiling impasse (when an agreement was reached before the X-date), the University of Michigan’s consumer sentiment index fell precipitously and the stock market declined. In short, the best one could hope for is a brief recession. A prolonged delay in lifting the debt ceiling would likely lead to a more severe contraction.

Debt Prioritization Could Quickly Run Into Challenges

Even with the prioritization of debt service, there could be legal and other operational challenges. The Treasury’s authority to prioritize debt service over benefits, wages, or other contractual payments could be contested by members of Congress or private citizens.

Similar legal challenges could arise if the Biden administration instructs the Treasury to ignore the debt limit or otherwise obtain financing through new instruments. Consequently, even if the Treasury appears to be making a good-faith effort to prioritize debt-service payments, nervous investors could reduce their participation in debt auctions, increasing the risk of a missed payment of principal. While the Federal Reserve might lend some help by restarting purchases of Treasuries, this could raise reputational risks and mire the Fed in similar legal challenges.

Debt Payment Delays Could Jeopardize Financial Stability

Any missed payment on Treasury securities would likely impair the functioning of U.S. capital markets. We would expect a near cessation of lending activity as banks simply try to ensure their short-term survival. Doubts regarding the safety and soundness of U.S. banks would increase over time, as even the reliability of FDIC insurance could come into question. Risk aversion would increase significantly, likely leading to a widening of credit spreads for many lower-quality borrowers.

Once this process starts in earnest, it could be difficult to stop, and the world economy would be in a significantly worse place.

With every passing day, the risk of the Treasury running out of cash increases. In our view, the high cost of inaction on the debt ceiling will very likely push legislators toward a last-minute agreement. Nevertheless, we will continue to monitor progress and take action on the country’s credit rating as necessary.

About DBRS Morningstar

The DBRS Morningstar group of companies consists of DBRS, Inc. (Delaware, U.S.)(NRSRO, DRO affiliate); DBRS Limited (Ontario, Canada)(DRO, NRSRO affiliate); DBRS Ratings GmbH (Frankfurt, Germany)(EU CRA, NRSRO affiliate, DRO affiliate); and DBRS Ratings Limited (England and Wales)(UK CRA, NRSRO affiliate, DRO affiliate). DBRS Morningstar does not hold an Australian financial services license. DBRS Morningstar credit ratings, and other types of credit opinions and reports, are not intended for Australian residents or entities. DBRS Morningstar does not authorize their distribution to Australian resident individuals or entities, and accepts no responsibility or liability whatsoever for the actions of third parties in this respect. For more information on regulatory registrations, recognitions and approvals of the DBRS Morningstar group of companies, please see: https://www.dbrsmorningstar.com/research/225752/highlights.pdf.

The DBRS Morningstar group of companies are wholly-owned subsidiaries of Morningstar, Inc.

© 2023 DBRS Morningstar. All Rights Reserved. The information upon which DBRS Morningstar credit ratings and other types of credit opinions and reports are based is obtained by DBRS Morningstar from sources DBRS Morningstar believes to be reliable. DBRS Morningstar does not audit the information it receives in connection with the analytical process, and it does not and cannot independently verify that information in every instance. The extent of any factual investigation or independent verification depends on facts and circumstances. DBRS Morningstar credit ratings, other types of credit opinions, reports and any other information provided by DBRS Morningstar are provided “as is” and without representation or warranty of any kind and DBRS Morningstar assumes no obligation to update any such ratings, opinions, reports or other information. DBRS Morningstar hereby disclaims any representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability, fitness for any particular purpose or non-infringement of any of such information. In no event shall DBRS Morningstar or its directors, officers, employees, independent contractors, agents, affiliates and representatives (collectively, DBRS Morningstar Representatives) be liable (1) for any inaccuracy, delay, loss of data, interruption in service, error or omission or for any damages resulting therefrom, or (2) for any direct, indirect, incidental, special, compensatory or consequential damages arising from any use of credit ratings, other types of credit opinions and reports or arising from any error (negligent or otherwise) or other circumstance or contingency within or outside the control of DBRS Morningstar or any DBRS Morningstar Representative, in connection with or related to obtaining, collecting, compiling, analyzing, interpreting, communicating, publishing or delivering any such information. IN ANY EVENT, TO THE EXTENT PERMITTED BY LAW, THE AGGREGATE LIABILITY OF DBRS MORNINGSTAR AND THE DBRS MORNINGSTAR REPRESENTATIVES FOR ANY REASON WHATSOEVER SHALL NOT EXCEED THE GREATER OF (A) THE TOTAL AMOUNT PAID BY THE USER FOR SERVICES PROVIDED BY DBRS MORNINGSTAR DURING THE TWELVE (12) MONTHS IMMEDIATELY PRECEDING THE EVENT GIVING RISE TO LIABILITY, AND (B) U.S. $100. DBRS Morningstar does not act as a fiduciary or an investment advisor. DBRS Morningstar does not provide investment, financial or other advice. Credit ratings, other types of credit opinions and other analysis and research issued by DBRS Morningstar (a) are, and must be construed solely as, statements of opinion and not statements of fact as to credit worthiness, investment, financial or other advice or recommendations to purchase, sell or hold any securities; (b) do not take into account your personal objectives, financial situations or needs; (c) should be weighed, if at all, solely as one factor in any investment or credit decision; (d) are not intended for use by retail investors; and (e) address only credit risk and do not address other investment risks, such as liquidity risk or market volatility risk. Accordingly, credit ratings, other types of credit opinions and other analysis and research issued by DBRS Morningstar are not a substitute for due care and the study and evaluation of each investment decision, security or credit that one may consider making, purchasing, holding, selling, or providing, as applicable. A report with respect to a DBRS Morningstar credit rating or other credit opinion is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. DBRS Morningstar may receive compensation for its credit ratings and other credit opinions from, among others, issuers, insurers, guarantors and/or underwriters of debt securities. This publication may not be reproduced, retransmitted or distributed in any form without the prior written consent of DBRS Morningstar. ALL DBRS MORNINGSTAR CREDIT RATINGS AND OTHER TYPES OF CREDIT OPINIONS ARE SUBJECT TO DEFINITIONS, LIMITATIONS, POLICIES AND METHODOLOGIES THAT ARE AVAILABLE ON https://www.dbrsmorningstar.com. Users may, through hypertext or other computer links, gain access to or from websites operated by persons other than DBRS Morningstar. Such hyperlinks or other computer links are provided for convenience only. DBRS Morningstar does not endorse the content, the operator or operations of third party websites. DBRS Morningstar is not responsible for the content or operation of such third party websites and DBRS Morningstar shall have no liability to you or any other person or entity for the use of third party websites.