Here’s what will happen to the economy as the debt ceiling drama deepens

Alicia Wallace, CNN

After the United States hit its debt ceiling on Thursday, the Treasury Department is now taking “extraordinary measures” to keep paying the government’s bills.

A default could be catastrophic and cause “irreparable damage to the US economy, the livelihoods of all Americans and global financial stability,” Treasury Secretary Janet Yellen warned.

Yellen told CNN’s Christian Amanpour on Friday that all Americans will feel the consequences.

“If that happened, our cost of borrowing would increase, and every American would see that their cost of borrowing would also increase,” Yellen said. “On top of that, failure to make payments due, whether to bondholders, Social Security recipients, or our military, will undoubtedly cause a recession in the US economy and could trigger a global financial crisis.”

She added: “This will certainly undermine the role of the dollar as a reserve currency that is used in transactions around the world. And Americans — many people — will lose their jobs, and of course their borrowing costs will go up.”

Dire warnings about problems with the debt ceiling are not new. Federal lawmakers have already reached agreements in the past, and the current Congress has some time – at least until early June, according to Yellen’s public estimates – to come to an agreement on whether to raise or suspend the debt limit.

Many economists say they expect an agreement to be reached. However, given the current “extremely turbulent political environment”, it could be a long process that will contribute to “outbursts” of volatility in financial markets, Moody’s Investors Service said in a note on Thursday.

Such volatility occurs at a time when the Federal Reserve is trying to reduce inflation by making a soft (or soft) landing with minimal damage to the economy.

Lessons from 2011

So what happens to the economy in a worst-case default scenario?

It’s an understandable question with an unsatisfactory answer, said Michael Pugliese, vice president and economist at corporate and investment bank Wells Fargo.

“The honest truth is that no one knows,” he said. “U.S. government default across the board is not something we’ve ever faced, and it’s not something we’ve ever come close to.”

While a default cannot be modeled like a more common economic event in history such as a recession, the events of 2011 may provide some insight into what would happen if the debt ceiling drama turned into a fiasco. said Gregory Dacko, chief economist at EY-Parthenon.

“In 2011, for the first time in a long time, we came close to exceeding the debt ceiling,” he said. “And it was a time when there was a lot of political fragmentation and a strong desire to essentially tie spending cuts to any increase in the debt ceiling.”

The current situation includes similar brinkmanship and a desire to cut costs, he said.

But some fear the fight could turn out to be tougher than in the past, a concern exacerbated by the fact that it took 15 ballots to elect the Speaker of the House, usually the lightest vote ever held by a new Congress.

The economy almost 13 years ago was also different.

The Fed was in loose monetary policy at the time, Pugliese said, and the economy was in a weaker position as it was still recovering from the 2008 Great Recession. Unemployment was north of 9% in July 2011.

That same year, the Treasury Department predicted that the “X date,” the date it would fail to meet its obligations on time, would fall on August 2, 2011. Ultimately, that was the date that Congress passed and President Barack Obama passed the law. Ceiling Law.

The actual economic impact of raising the debt ceiling in 2011 is difficult to isolate and quantify, Pugliese said, noting that the sluggish economic recovery in the US has also been side-effected by global events, in particular the sovereign debt crisis in Europe.

Still, he said, there were some signs that the protracted congressional infighting was contributing to the shake-up in the economy. Real GDP growth in the third quarter of 2011 was weak -0.1% qoq on an annualized basis. Financial markets were flustered, consumer confidence weakened, the U.S. policy uncertainty index set a new high, and The credit rating agency downgraded the US rating to AA+ from AAA.

“I think it would be hard for you to say [the debt ceiling debacle] was a positive thing,” he said. “I think of it more as another hurdle among many other hurdles for the economy as it came out of 9 percent unemployment at the time.”

“Date X” and its ripple effects

This time around, if the X date comes without a decision, there is speculation that the Treasury could prioritize principal and interest payments to prevent a technical default, Pugliese said. There are potentially other “break the glass” options from the Treasury and the Federal Reserve, but these are untested and short-term solutions, he added.

“Someone, somewhere, will be left out if the government doesn’t have all of their money, be it Social Security recipients, defense contractors, civil servants, veterans, [etc.],” he said.

Adding to the uncertainty is the current economic climate, Dako said.

“We are entering this delicate period at a time when the US economy is clearly slowing down, and at a time when the global economic backdrop is also weakening… so the economic environment against which this debt ceiling fiasco is unfolding is one factor in the amplification of economic easing. . “.

While a self-induced recession is likely after date X, some shocks could come sooner, Daco said.

“Financial markets and private sector participants tend to react before this date,” he said. “If there is an expectation that we will be very close to this critical date, then financial market volatility tends to increase and stock prices tend to react unfavorably.”

A Treasury default will undermine the global financial system, said Louise Scheiner, policy director at the Hutchins Center for Fiscal and Monetary Policy and a former senior economist at the Fed and the Council of Economic Advisers.

“If Treasuries become something that people worry about, then it will have ripple effects in capital markets around the world that are really hard to predict,” she said.

Given the potential impact in the United States and abroad, Shainer believes the debt ceiling will be lifted or suspended – eventually.

“There is no other way out,” she said. “There is no way Congress will cut spending by 20% in the middle of the year. This would plunge the economy into recession. That would be a terrible policy.”

She added: “If you’re taking care of long-term debt, you have to actually change various laws, social security law, health care or tax laws… you want to do it in the proper process, you want to do it well thought out.” outside. It’s not something that should be done under duress.”

CNN’s Megan Vasquez, Matt Egan and Tami Luhby contributed to this report.

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