Five ways a debt ceiling crisis could derail the US economy

The biggest threat the US economy faces this year could be the fight over the federal debt limit.

Congress and the White House have about six months to avoid an unprecedented and potentially catastrophic default on the federal debt. But there is no clear path to keeping the US solvent, with House Republicans fiercely opposed to any increase in the debt ceiling unaccompanied by serious spending cuts.

If lawmakers fail to reach an agreement to avoid default, experts say the shock could plunge the world into a recession and financial crisis. Even a prolonged standoff over the debt ceiling could upset markets and derail a global economy already weakened by inflation, rising interest rates and the lingering scars of the COVID-19 pandemic.

“There are a number of economic challenges that exist beyond the fact that the debt limit negotiations are necessary,” said Rachel Snyderman, senior associate director at the Bipartisan Policy Center (BPC), in an interview on Tuesday. The BPC is a bipartisan think tank that closely follows the debt limit and how long the Treasury Department can avoid a default through extraordinary measures.

“The clock is really ticking for lawmakers to get serious about finding a solution together to not only address the debt limit, but I think to have a broader discussion about our nation’s fiscal challenges,” he said.

Rising recession risks

The Federal Reserve in Washington, DC

The Federal Reserve in Washington, DC, is seen on Monday, September 16, 2019. (Greg Nash)

A showdown over the debt limit is still risky, but the chances of serious damage are even higher as American businesses and households prepare for a potential recession.

Many economists are already expecting the US economy to slow into a recession after two years of high inflation and The increase in interest rates of the Federal Reserve. Other economists are more optimistic and expect the US economy to simply stagnate for a few quarters, but few experts expect another year of strong and steady growth.

Snyderman said an economic slowdown could shorten the window to raise the debt ceiling by depriving the federal government of much-needed tax revenue. Congress could also struggle to find the money to prevent a deeper recession if its hands are tied by debt ceiling negotiations or the inability to borrow money to finance stimulus.

“If the government needed to respond to an economic downturn, its toolkit would be more limited,” he said.

Global financial crisis

Both the US dollar and Treasury bonds are considered among the safest assets in the world. (The Associated Press)

If the United States fails to remain solvent and default on its debt for the first time, the implications for financial markets could be dire.

The US dollar is strengthening as the world’s reserve currency thanks to the global faith in the ability of the federal government to always pay its debts.

Banks, financial firms, companies and sovereign nations use trillions of US dollars and Treasury bonds to bolster their assets and make international transactions, making the United States indispensable in the global financial system.

Both the US dollar and Treasury bonds are considered among the safest assets in the world. But a default on the national debt will show the world that the US dollar and Treasury bonds can not be trusted, inducing a crisis of confidence that could tank the global financial system.

“To fail [raise the debt limit] it would literally be Congress choosing not to pay the government’s bills,” Snyderman said.

“We have access to capital markets. We have the ability to issue more debt. This is not like developing countries in the past that did not have this type of access, and they have no other alternatives than the default,” he continued. “A US default would be purely a political decision.”

Americans could lose crucial federal benefits

House Speaker Kevin McCarthy (R-Calif.) speaks during a news conference in Statuary Hall on the Capitol in Washington, Thursday, Jan. 12, 2023. (AP Photo/Jose Luis Magana)

A default on the national debt prevents the federal government from spending hundreds of billions of dollars on programs that millions of Americans depend on for food, medical care and basic needs.

House Republicans are expected to propose a bill that would direct all federal revenue toward payments to debt holders and away from social safety net programs if the United States runs out of ways to avoid a default.

Experts say entitlement programs like Social Security and Medicare — for which the Treasury manages spending — could also be at risk if the government defaults on its debt.

“If we reach the debt ceiling, and the Treasury comes out with extraordinary measures, and they can’t really meet their obligations, someone will not be paid,” David Wessel, director of the Hutchins Center for Fiscal and Monetary Policy at the Brookings Institution, told The Hill in a recent interview.

“It could be someone who owns a Treasury bond. It could be a Social Security recipient,” Wessel said.

Data from the Treasury showed Social Security leading a list of the top 10 categories and agencies for government spending in fiscal year 2022, with a price tag of more than $1.2 trillion. Medicare came in fifth on the list, amounting to more than $750 billion for the 12-month period ending at the end of September.

Both programs are on track for insolvency in the coming years, with Medicare about six years from being insolvent and about twice that time remaining for Social Security, according to the Committee for a Responsible Federal Budget.

Some Republicans have expressed interest in recent months in seeking potential reforms to such programs as part of debt-limitation talks with Democrats. However, other Republicans have pushed back on proposals to leverage negotiations for concessions on entitlement programs since the party took over the House this month.

Higher interest rates

The Capitol is seen in Washington, Monday, Oct. 4, 2021. (AP Photo/J. Scott Applewhite)

The nation could also see higher interest rates on its debt as a potential consequence, experts warn.

“US Treasury debt is considered the most risk-free lending instrument in the world because the United States has had a long, long history of not only recognizing interest, but then repaying the principal of the debt when it is due.” Paul Van de Water, senior fellow at the Center on Budget and Policy Priorities, told The Hill.

“So anything that makes the US government look like a less trustworthy lender will raise the interest rate lenders charge to lend money to the US Treasury,” he added.

Van de Water, a former analyst at the Congressional Budget Office, also said that such an impact could extend to costs that are harder at home for Americans, warning of potentially higher interest rates in the country since many loan rates can be linked to Treasury rates.

“Individual rates on home mortgages and credit card debt will increase, rates on loans from other countries may increase,” he said. “And of course, when you have an increase in interest rates, that slows down the economy, because the expectation of a slower economy can also have negative effects on the stock market.”

Decline in public confidence

The Treasury building is seen in Washington, on May 4, 2021. (AP Photo/Patrick Semansky, File)

Polls show a vast majority of Americans already disapprove of how Congress is handling its work, and experts doubt that dissatisfaction will improve if lawmakers manage to eliminate what would be an unprecedented default this year if they fail to act the tax limit the debt

According to the Peter G. Peterson Foundationthe debt limit has been raised nearly 90 times under Republican and Democratic administrations over the past 63 years.

However, the task has become increasingly partisan over the years, with both sides engaged in pitched battles to the very end before eventually avoiding a default.

Republicans are for significant spending cuts as part of concessions they hope to win from Democrats in the debt limitation negotiations. By contrast, the Democrats insisted on a clean bill to address the debt limit, while they pushed on the proposals of the Republicans to reduce certain expenses.

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