Another debt ceiling crisis is approaching, and it is in no one’s best interest.
Policy brinksmanship over lifting the debt ceiling and the threat of default it brings is increasing the cost of doing business and carries far more risk than is commonly acknowledged. At its core, the stand-off is an artificial crisis induced by the political authority that will be difficult to contain if it is allowed to spiral out of control.
But what happens if a default takes place? To better understand the risks—and they are substantial—we modeled out a number of scenarios to estimate the probable outcomes on employment, growth and inflation. In a separate article, we also offer answers to some basic questions.
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A technical default
The first scenario is a technical default, which is defined as an extended period of nonpayment of some or all U.S. financial responsibilities. Based on our shock model, a technical default would double the current unemployment rate of 3.4% to near 7%, tip the economy into recession within six months and, following a short bout of disinflation, result in a more persistent bout of inflation accompanied by a deterioration in the fiscal condition of the economy.
An actual default
The second scenario would be an actual default, in which the government, out of money, stops paying its obligations. It would be an unfettered economic catastrophe. Our model indicates that unemployment would surge above 12% in the first six months, the economy would contract by more than 10%, triggering a deep and lasting recession, and inflation would soar toward 11% over the next year.
Under both scenarios, the U.S. credit rating would be downgraded, the dollar would be put in jeopardy and the cost of floating debt for both the American private sector and government would rise.
In addition, the small and medium-size enterprises that comprise the backbone of the American economy, unable to absorb such a shock, would suffer irreparable harm.
Based on the experience of the 2011 and 2019 debt ceiling stand-offs, our base case is that the political authority will tempt fate, courting default and putting domestic and international economic stability at risk, before striking a deal.
But the deal would not accomplish much in the way of addressing the government’s long-term spending imbalance. The primary budget deficit—the deficit less interest owed on past debt, which in our estimation is the correct metric to focus on to achieve fiscal stability—stands at 3.27% of gross domestic product.
Putting the primary budget deficit on a path to a more sustainable rate of 2% over the next decade is something that the political authority could accomplish outside an unnecessary and artificially induced crisis.
Lessons learned
To better understand the risks, we simulate what a debt ceiling crisis would look like using two scenarios: the 2011 debt crisis and the 2008-09 financial crisis.
The 2011 debt ceiling crisis pushed down asset prices, reduced household spending and private business investment, and eroded consumer and corporate confidence. Even though the 2011 debt crisis was more benign than the financial crisis, a modest technical default along those lines that drags on for a few weeks would still damage the U.S. economy.
The 2008-09 financial crisis, by contrast, serves as a better comparison if there is a full-scale default. The impact of such a default would be transmitted through the economy through the financial markets that would affect the real economy following a short lag. The results would be catastrophic.
Debt ceiling shock model
We use the Chicago Board of Exchange’s options volatility index, or the VIX, as a proxy for financial and economic risk and uncertainties and the one-year credit default swap rate as a proxy for credit risks.
Both serve as leading indicators when shocks take place to identify their full impact on growth, inflation and unemployment through a vector autoregression model, which captures the relationship among multiple factors over a period of time.
Our choice of proxies was motivated by the anticipation that the financial markets would be the initial channel through which the economy would be subject to stress. Our findings indicate that the selected proxies have strong correlations, with a 95% confidence level.
For instance, an increase of one standard deviation in the VIX would result in a decline of approximately 1.7 percentage points in gross domestic product on an annualized basis during the subsequent quarter. This decline would persist over the following two quarters before turning positive.
It will be some time—we think between July and September—before the U.S. government reaches a date that risks default. It is reasonable to assess the economic impacts from the last quarter of 2023 to the end of 2025.
During the depth of the 2008-09 financial crisis, market uncertainties stayed extremely elevated for nearly nine months—with the VIX at an average of 3 standard deviations above neutral. On top of that, the one-year rates on credit default swaps rose more than 40 basis points in six months.
If the same market movements took place this time because of a government credit default, the consequences would most likely be worse.
This underscores our analysis that the current crisis is already subjecting the economy to financial stress that is increasing the cost of doing business.
The economy would immediately sink into a deep recession in the following quarter, with a decline in gross domestic product exceeding 10%. The recession would last into next year before an economic rebound in 2025.
In that scenario, total GDP loss would approach $700 billion while 11 million jobs would be lost.
The key difference from the 2008-09 crisis is that the economy is on a trajectory to experience a mild recession during the second half of this year, while inflation remains at a multidecade high. The policy tool set to fix a deep recession today is, therefore, limited and the probability of self-induced deep recession would increase substantially.
As uncertainties and credit default swap rates rose, the first-order effect on pricing would be a sharp fall in the overall inflation rate. The model, however, assumes that both monetary and fiscal authorities would swiftly reduce the federal funds rate and increase fiscal support. This time around, though, reducing the federal funds rate may not prove sufficient to bring down long-term interest rates.
While both the monetary and fiscal actions would eventually lift the economy out of a recession, the inflation costs would be immense. Built upon the current level of sticky inflation, inflation could reach above 10% as the economy bounces back from the aftermath of the deep recession.
Still, we believe that there is less than 10% chance of a full-scale payment default. A more likely scenario, while undesirable, is a situation like 2011, when the negotiation over the debt limit went down to the wire.
If that happens, the costs on GDP would be up to $200 billion, and 4 million jobs would be lost.
In both scenarios, we do not assume a lasting default on U.S. government debt, which would be much more devastating.
It is important to bear in mind that the two scenarios we have modeled, a technical default versus a full-scale default, are based on historical events and are intended to provide benchmarks for evaluating the potential consequences of a default.
But no two crises are identical. With the current state of the economy, in which inflation is constraining both fiscal and monetary policy, we anticipate that our estimates of GDP declines, the number of lost jobs and the unemployment rate could be subject to upside risks.
The takeaway
The debt ceiling stand-off is already raising the cost of issuing debt by both public and private actors.
While our baseline forecast indicates that a true catastrophe will be averted at the last minute, the idea of a relatively benign outcome similar to the 2011 crisis would appear to be somewhat of a rosy scenario given current conditions.
If the policy brinksmanship fails to produce a compromise, there would be a significant impact on overall output, inflation and employment.
Small and medium-size enterprises that do not have the resources to survive such a crisis are especially vulnerable to insolvency risks under such conditions. In the end, households will bear the burden of another failure on the part of the American political authority.
