The recent U.S. debt ceiling debacle has shed light on just how dangerous a polarized and fragile political landscape can be for the American public. While the U.S. economy narrowly avoided defaulting on its debt on multiple occasions (both due to the debt ceiling as well as the appropriations bills that need to be passed to spend money directed by Congress), it’s clear that trouble continues to bubble underneath the surface in Washington. Until something changes in terms of how the Constitution is written and interpreted, we could see similar potential national debt default scenarios play out.
Now, the question is exactly what would happen, both in terms of economic and societal impact, if the U.S. were to indeed default on its debt.
As the political deadlock continued and the nation neared the point where it couldn’t meet all financial obligations, numerous economists predicted the dire economic consequences of a U.S. debt default. These included a loss of faith in the government’s ability to pay bills promptly, credit rating downgrades and financial market turbulence.
But how does it entirely affect both the average investor and consumers? Let’s discuss three dire consequences that could arise from a U.S. default in 2023.
What Is the Debt Ceiling?
The debt limit, created in 1917, caps the amount of federal debt the U.S. government can have. In June 2023, lawmakers suspended the debt ceiling until January 2025 after reaching the $31.4 trillion limit months earlier. Since 2001, the government has run an average of nearly $1 trillion deficit each year, making it necessary to borrow funds to cover expenses. During the 2023 fiscal year, the government spent $6.13 trillion but only collected $4.44 trillion, leaving a deficit of $1.7 trillion — nearly double its 2019 level.
Raising or suspending the debt ceiling through congressional action doesn’t alter the nation’s financial obligations. These changes demand a majority in the House and 60 Senate votes.
Understanding a National Debt Default
A breach of the U.S. debt ceiling would severely harm the economy. Studies, including those by CEA and external researchers, show that if the government defaulted on obligations to creditors, contractors or citizens, the economy would swiftly decline. The extent of losses would depend on the breach’s duration. A prolonged default would likely lead to severe economic damage, with job growth shifting from robust gains to millions of losses.
In simple terms, a government debt default could undo the economic progress achieved since President Biden took office, including a record-low unemployment rate, the creation of 12.6 million jobs and strong consumer spending. A default-induced recession would limit the government’s ability to use counter-cyclical measures to help households and businesses.
Borrowing through the private sector to mitigate the economic pain would also be challenging. The risks from default would cause interest rates to soar, affecting financial instruments like credit card interests, treasury bonds and mortgages used by households and businesses.
Consequences of a National Debt Default
A consensus among economic experts, spanning political views, held that a default on U.S. obligations would bring severe, enduring consequences domestically and globally. These repercussions included widespread job losses, elevated borrowing costs and a diminished economy — as elaborated below.
Moody’s Analytics forecasted that a default lasting until the year’s end could trigger a recession akin to the global financial crisis. That would result in a job loss of nearly 6 million and a stock market decline of almost one-third, erasing $12 trillion in household wealth. The inability to employ counter-cyclical policies would worsen the recession’s impact.
A debt ceiling breach would swiftly impact the economy. According to Mark Zandi, Chief Economist of Moody’s Analytics, even a brief default would trigger a crisis marked by soaring interest rates, falling stock prices and the shutdown of essential short-term funding markets. Fitch Ratings warns that the U.S. credit rating would be downgraded to “RD” (restricted default) with affected Treasury securities rated as “D” until the default is resolved.
Moody’s warned that a lasting debt limit breach could reduce real GDP, cause nearly 2 million job losses, and raise the unemployment rate from 3.5% to nearly 5%. It could also lead to lasting higher interest costs and jeopardize the risk-free status of Treasury securities. Brookings cited a previous analysis estimating that a default could increase federal borrowing costs by more than $750 billion over the next decade. Peterson Institute economists argued that it would weaken the dollar’s role globally and increase its volatility — but admitted there was no clear alternative to the dollar for a global reserve currency.
#1 It will undermine business and consumer confidence
Default would erode consumer and business confidence, curtailing essential spending for economic growth. It would also diminish investor confidence, causing stock prices to decline and devaluing family savings, as witnessed during the 2011 debt ceiling debate when the S&P 500 dropped about 15 percent.
A U.S. debt ceiling breach would severely harm the economy. Analysis by CEA and outside researchers shows that if the U.S. government defaulted on its obligations, the economy would suffer, with the severity depending on the breach’s duration. A protracted default could lead to significant economic damage, with job losses reaching into the millions.
A U.S. government default would hinder counter-cyclical measures, limiting options to help households and businesses. Borrowing options through the private sector, especially for small businesses, would be compromised, leading to skyrocketing interest rates on various financial instruments.
#2 It disrupts financial markets
While there’s no past instance of the U.S. defaulting on its debt, economists concur it would lead to avoidable economic calamity. Analysts from the Brookings Institution, Wendy Edelberg and Louise Sheiner, emphasized that “worsening expectations of a possible default would make significant disruptions in financial markets increasingly probable.” This would probably entail falling stock prices, diminished confidence among consumers and businesses, and restricted “access to private credit markets.”
Defaulting could destabilize the global financial system, as the world relies on the dollar’s stability. A loss of confidence could lead to economic and foreign policy consequences, with other countries promoting their currency for global trade. Short-term impacts include disrupting supply chains and affecting energy prices. A U.S. default would also harm other economies and reduce global demand.
#3 U.S. credit will be affected
Default would likely trigger a downgrade in the U.S. government’s credit rating, leading to increased interest rates. That would hinder economic growth, raise borrowing costs for businesses and families and elevate federal borrowing expenses. Investor unease might also prompt a downgrade and higher interest expenses.
FitchRatings stated in April that a heightened risk of default could result in negative rating actions, possibly moving the U.S. rating to “RD” (restricted default) and Treasury securities to a “D” rating. “Prioritizing debt payments to avert immediate default” may further impact the country’s rating, which already fell from AAA to AA+ in August.
Additionally, a default could trigger a recession, Jacob Lew stated in April 2023. Goldman Sachs (NYSE:GS) economists estimated it would halt one-tenth of U.S. economic activity. A default might result in the loss of three million jobs, increase the average 30-year mortgage cost by $130,000 and raise interest rates sufficiently — increasing the national debt by $850 billion.
Why Is Debt Default a Threat?
According to PriceWaterhouseCoopers, the U.S. GDP was anticipated to reach $34.1 trillion by 2050. The CBO projected that with debt at 175% of GDP, the estimated U.S. public debt in 28 years would soar to around $59.7 trillion. High and rising debt as a percentage of GDP could hinder economic growth, increase interest payments to foreign debt holders, raise fiscal crisis risks and constrain policy options for lawmakers — according to the CBO’s analysis.
When the debt ceiling is reached, the government faces limitations in borrowing funds to cover its expenses. The Treasury can employ “extraordinary measures” to prevent an immediate default, such as delaying payments and using cash from taxes. Some unconventional ideas, like minting a multitrillion-dollar platinum coin, have been suggested but are often seen as impractical.
Debates persist over the constitutionality of the debt ceiling, but legal challenges would likely follow if the Biden administration invoked this argument. In 2011, House Republicans used the debt ceiling to curtail discretionary spending under former President Barack Obama. Investors are bracing for potential impacts of the upcoming debt ceiling battles, with economists at Goldman Sachs highlighting increased fiscal risks this year.
On the date of publication, Chris MacDonald did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
