What Happens if the Debt Ceiling Isn’t Raised?
DBRS Morningstar: Even without a default, there could be significant economic impacts.
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.
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