The inability of the political sector to reach an equitable compromise on lifting the U.S. debt ceiling will come into sharp focus over the next few days.
The costs of a debt-ceiling crisis includes slower growth, higher unemployment and potentially a lower credit rating.
The federal government will exhaust its funding on Thursday, but can temporarily remain in operation because of special measures taken by the Department of Treasury. A debt ceiling crisis would result in a modest decline in inflationary pressures that have increased of late.
If there is no agreement over the next three to four weeks, conditions will be ripe for a crisis that will create at the least a 1% drag on growth, reduce employment by up to 1.2 million jobs, alter the nation’s credit rating and almost certainly postpone the Federal Reserve’s plan to reduce tapering operations.
This would be the first artificially induced debt ceiling crisis since the 2011 debacle, and has the potential to hurt the real economy, global financial markets and the credit rating of the United States.
If the debt ceiling were not to be increased, the federal government would suspend payments on social security, wages paid to members of the military and federal government, as well as payments on veteran’s benefits.
Just as important, households and firms with loans and credit lines linked to Treasury yields would experience an almost immediate increase in the cost of servicing those loans, which carries the risk of seriously disrupting the real economy.
Our simulations
We simulated how such an impasse would play out in the real economy. The result is 15 different scenarios that demonstrate a significant impact on growth and employment even in a short-term crisis. And of course a full-scale default is simply not an option. That would create the conditions for a far worse global systemic financial and economic crisis than the one that followed the Lehman Brothers bankruptcy in 2008.
In a recent research note, we estimated that, after taking into account special measures by the Treasury, the federal government would run out of funds around Nov. 2.
Because of the pace of spending, that now looks to be closer to Oct. 20 or sooner. That possibility will almost certainly begin affecting credit markets, consumer and corporate confidence, and broader asset markets in the coming days.
Shock to the economy
In this exercise, we estimate the impact of not raising the debt ceiling on the real economy and financial markets. We subject credit risk on five-year rates through increases by 50, 100 and 200 basis points while we subject uncertainty, which remains unchanged in one scenario, to one, two, three and five standard-deviation shocks in the others.
To provide context around that approach, a two-standard deviation increase in uncertainty is equivalent to the risk that accompanied the U.S.-China trade war in 2018. That trade war led to recessions in both the domestic and global manufacturing sectors.
Underscoring this approach is the well-learned lesson in recent decades that rising credit risks and uncertainties can significantly raise the potential for collateral damage to the economy.
To be clear, a recession does not take place in all 15 scenarios, but the drag on GDP would be substantial: Even a short-term default crisis carries with it the probability of a 0.99 percentage point decrease in fourth-quarter growth this year and up to a 1.76 percentage point decrease in the annual growth rate next year.
The immediate loss in GDP during the final three months of this year would range from no loss to $48.85 billion. That loss would be driven by the levels of uncertainties modeled through standard-deviation shocks. Annual GDP loss next year would range from $21.93 billion to $401.23 billion, while by 2023, cumulative GDP loss would range from $72.53 billion to $436.66 billion.
The effect on unemployment would be relatively small this year, causing an increase in the unemployment rate of 0 to 0.29 percentage points. But it would cause a significant increase in unemployment next year and in 2023. Over the next two years, the unemployment rate based on our simulations would most likely increase by 0.74 percentage points, which is equivalent to about 1.2 million jobs lost.
Our simulations do not assume a lasting default on U.S. government debt, which would be much more devastating. We consider only the scenarios when the shocks from the debt ceiling risk are temporary. Despite the game of political brinksmanship that is making headlines, we still anticipate that Congress will act to resolve the issue.
The takeaway
The political fallout of a short default period or a government shutdown, even for a few days, would be extremely costly because the economy has been under immense pressure from the resurgence of the coronavirus this year.
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