What Would Happen If America Defaulted On Debt Obligations? 3 Things To Know About The Debt Ceiling

What Would Happen If America Defaulted On Debt Obligations? 3 Things To Know About The Debt Ceiling

debt ceiling default

Images: U.S Capitol building in Washington, D.C. June 9, 2022. (AP/Patrick Semansky, File) / Dollar airlpane: Lee Cannon, https://www.flickr.com/photos/leecannon/ https://creativecommons.org/licenses/by-sa/2.0/

The U.S. has reached its debt limit, and while it has come close but never before defaulted on its obligations, government analysts agree that a default of its $31.4 trillion debt ceiling as soon as June 1 would lead to immediate and deep recessionary conditions.

If the U.S. government defaults on its debt, the far-reaching effects could include shock waves in financial markets, bankruptcies, recession and potentially irreversible damage to the U.S.’s standing as the center of the global economy.

The probability of a default is low if opposing lawmakers come through on their assurances that a deal will be made to raise or suspend the debt limit, New York Times reported.

If there is no deal, the economy would quickly shift into reverse with severe damage likely, according to a simulation and analysis by the White House Council of Economic Advisors (CEA) and outside researchers. Job growth would swing from its current gains to losses numbering in the millions.

A CEA simulation of the effects of a debt ceiling breach suggests that in the third quarter of 2023, the stock market could plummet 45 percent, affecting retirement accounts. A hit to consumer and business confidence could lead to a pullback in consumption and investment. Unemployment could increase an estimated 5 percent as businesses lay off workers and consumers cut consumption.

The CEA simulation was based on shocks to consumer and business confidence that mimic the Great Recession with increased interest rate premiums and 20-to-30 percent cutbacks in government spending.

Unlike the Great Recession and the covid recession, the government would be unable to help consumers and businesses.

Here are some things to know about the debt ceiling.

Default would lead to extreme market volatility

The $24 trillion U.S. Treasury market is the largest debt market in the world and the primary source of financing for the government. It’s integral to the dollar, the most widely used currency in the world, and Treasury debt is even treated as the equivalent of cash because of the U.S. government’s reputation for creditworthiness.

The global financial system hinges on U.S. government bonds so it’s difficult to predict the damage a default would create, but executives expect massive volatility across equity, debt and other markets.

The ability to trade in and out of Treasury positions in the secondary market would be severely impaired in the event of a U.S. government debt default, Reuters reported.

Fast-spreading market dysfunction

Wall Street executives who have advised the Treasury’s debt operations warned that Treasury market dysfunction would spread fast to the commodity, derivative, and mortgage markets. Investors would question the validity of Treasuries widely used as collateral for securing trades and loans. Financial institutions could ask counterparties to replace the bonds affected by missed payments, analysts said.

Even a short debt limit breach could lead to higher interest rates, lower equity prices, and violations of loan documentation and leverage agreements.

Short-term funding markets would likely freeze up as well, according to Moody’s Analytics.

Higher interest rates

A prolonged government default could make homes unaffordable for hundreds of thousands of would-be buyers, sending mortgage rates up as high as 8.4 percent from the current rate of about 6.4 percent today, according to an estimate by the real estate website Zillow.

“This scenario would be like a one-two punch hitting homebuyers who are already reeling from the affordability challenges this year in the market,” says Jeff Tucker, a senior economist at Zillow. “That would discourage a lot of sales.”

If a default was remedied in a day or two, effects might be muted, but if government bills go unpaid for weeks or months, it could have a lasting effect on interest rates, NPR reported.

“If that gets shaky, that sends earthquakes out through the whole credit system,” Tucker said. “Would that cause a permanent increase in borrowing costs? We don’t really know for sure. And I think, frankly, that’s all the more reason not to find out.”

Images: U.S Capitol building in Washington, D.C. June 9, 2022. (AP/Patrick Semansky, File) / Paper airplane: Lee Cannon, https://www.flickr.com/photos/leecannon/ https://creativecommons.org/licenses/by-sa/2.0/