The debt ceiling sets a limit on how much debt the US government can incur. It dates to 1917 during World War I and was revised during the 1930s, two periods where government spending had soared.
Unfortunately, a split Congress and increased political polarisation are likely to cause delay. So far, most House Republicans are opposed to any increase in the debt limit without future spending cuts and other reforms.
Barring the Treasury’s accounting manoeuvres, the US was expected to reach its statutory debt limit in January. Since then, the US Treasury began to defer payments in order to keep the federal government running.
Sadly, a US debt limit standoff which raises the risk of default would stress an economy that is already under pressure due to persistently high inflation and higher interest rates. And, a US default could have disastrous consequences for the global economy, costing millions of American workers their jobs, disproportionately hurting Americans savers and their retirement plans much worse than foreign investors.
While a standoff could have a large negative impact in the short run, the effects won’t be long lasting and it’s likely that the worst-case scenario will be avoided. This is because there aren’t many alternatives for the large size of the US economy, the relative strength of its institutions and its larger Treasury bond market.
The heightened risk of default and an eventual default would cause severe economic pain at home first. And the after-shocks would reverberate around the world.
First, more than two-thirds of the US marketable securities are owned by Americans. 76 per cent of total federal government debt is in marketable securities held by the public - mostly Americans. At US$7.3 trillion[i], foreigners only held slightly more than 30 per cent of US public debt at the end of last year according to data from the US Treasury.
Second, higher default risk would cause borrowing costs to increase hurting consumers and businesses and potentially pulling the US economy into a recession. In 2011, the mere threat of default caused stock prices to plunge, led to higher market volatility and interest rates increased as America’s credit rating was downgraded for the first time.
Lastly, since financial institutions borrow to meet their obligations by using Treasury securities as collateral, a default would render that collateral worthless. That would reduce banks’ ability to borrow, to make cash available to depositors - households and businesses - which could cause a widespread panic, potential bank runs and a financial crisis.
Historically, US debt has been deemed the world’s safest asset. The loss of credibility from a default could upend global financial markets.
The economic impact would be disastrous…
Research shows[ii] that a default would result in job loss for millions of workers, raise the current unemployment rate from 3.5 per cent to above 12 per cent in the first six months, causing the economy to contract by more than 10 per cent.
Pension and retirement plans are some of America’s biggest bond buyers with roughly 15 per cent of the marketable securities held by Americans. Default would harm most of America’s retirees.
One-year credit default swaps tell part of the story
Since the credit default swaps (CDS) price depends heavily on the default risk, credit default swaps spreads can be used to predict the risk of default.
Credit default swaps (CDSs) - the most liquid contracts in the credit derivatives - are analogous to insurance against default; the buyer of the credit derivative contract, or protection buyer, pays a fee, or CDS spread, in exchange for protection against the risk of default. In case of default, the protection buyer delivers the bond to the protection seller in exchange for the face value of the bond or loan.
The price of one-year US credit default swaps has already soared[iii] above the levels observed at the onset of the global financial crisis and during the 2011 debt ceiling crisis. The rise is an indication that investors are trying to hedge against the risk of a US default.
Thankfully betting on a US default has never been a worthwhile endeavour. The debt ceiling has been raised 45 times in the last 40 years meaning the worst-case scenario will likely be avoided. Although previous debt limit standoffs have led to higher stock market volatility, the effects did not last very long and the US Treasuries remained the premier safe asset for financial market participants around the world. This is partly because there aren’t many alternatives.
Safe assets are those with a high likelihood of repayment and are easy to value and trade. But ultimately, the safety of the asset is partly determined by investor behaviour. The larger size of the US economy, the relative strength of its institutions and its larger Treasury bond market make it unlikely that this latest hiccup will have lasting consequences.
Dr Orphe Divounguy
Orphe Divounguy is a Senior Economist at Zillow Group Inc. Divounguy is the former Chief Economist at the Illinois Policy Institute. Divounguy is also the founder of the Quantitative Research Group and the co-host of the Everyday Economics podcast. Divounguy’s columns and articles cover fiscal policy, labor economics, and quantitative methods for programme and policy evaluation. Contact: email@example.com. The views presented here do not necessarily reflect the views of his employers.