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

CNN

By Alicia Wallace, CNN

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

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

Yellen on Friday told CNN’s Christiane Amanpour that the impacts would be felt by every American.

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

She added: “It would certainly undermine the role of the dollar as a reserve currency that is used in transactions all over the world. And Americans — many people — would lose their jobs and certainly their borrowing costs would rise.”

Dire warnings of debt ceiling trouble aren’t new. Federal lawmakers have reached agreements in the past, and this Congress has some time — until at least early June, according to Yellen’s public estimates — to reach an agreement on whether to raise or suspend the debt limit.

Many economists say they expect an agreement will be reached. However, given the current “extremely fractious political environment,” it could be a long process that would contribute to “flare-ups” in financial market volatility, Moody’s Investors Service said in a note Thursday.

Such volatility is coming at a time when the Federal Reserve is trying to bring down inflation while navigating a soft (or softish) landing with minimal harm to the economy.

Lessons from 2011

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

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

“The honest truth is, no one knows,” he said. “A widespread default by the US government is not something we’ve ever experienced and not something we’ve ever even come close to experiencing.”

While a default isn’t something that can be modeled in the way a more historically common economic event such as a recession can be, the events of 2011 could lend some perspective as to what would happen if the debt ceiling drama turns into a debacle, said Gregory Daco, chief economist at EY-Parthenon.

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

The current environment includes similar brinksmanship and desires to attach spending cuts, he said.

But some fear this fight may be tougher than those in the past, a concern reinforced by the fact it took 15 ballots to elect the Speaker of the House in what is normally the easiest vote taken by a new Congress.

The economy nearly 13 years ago was different, as well.

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

That same year, Treasury projected the “X date” — the date on which it would be unable to pay its obligations on time — would fall on August 2, 2011. That ultimately was the date when Congress passed, and President Barack Obama enacted, a law increasing the ceiling.

The actual economic impact of the debt ceiling run-up in 2011 is hard to isolate and quantify, Pugliese said, noting how the sluggish US economic recovery also experienced spillover effects from global events, notably Europe’s sovereign debt crisis.

Still, there were some indications that the protracted congressional battle contributed to a shake-up in the economy then, he said. Real GDP growth was a weak -0.1% on a quarter-over-quarter annualized basis in the third quarter of 2011. Financial markets were roiled, consumer confidence weakened, the US economic policy uncertainty index set a new high and Standard & Poor’s credit rating agency downgraded the United States to AA+ from AAA.

“I think you would be hard pressed to say [the debt ceiling debacle] was a positive thing,” he said. “I think of it more as one other hurdle among a lot of other hurdles for the economy as it emerged from 9% unemployment at the time.”

The ‘X date’ and its ripple effects

This time, if the X date were to come without a resolution, 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 Federal Reserve, but those are untested and short-term solutions, he added.

“Someone, somewhere is going to get shortchanged if the government doesn’t have all of its money, whether that’s Social Security beneficiaries, defense contractors, civil service employees, veterans, [etc.],” he said.

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

“We are going into 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 debacle is unfolding is one of increased economic softening.”

While a self-inflicted recession would be likely after the point when an X date is hit, some upheaval could come sooner, Daco said.

“Financial markets and private sector actors tend to react ahead of that date,” he said. “If there is the anticipation that we will get very close to that drop-dead date, then financial market volatility generally tends to increase, stock prices tend to react adversely.”

A Treasury default would undermine the global financial system, said Louise Sheiner, policy director at the Hutchins Center on Fiscal and Monetary Policy and former senior economist with the Fed and the Council of Economic Advisers.

“If Treasuries become something that people are worried about holding, then that has ripple effects throughout capital markets throughout the world, in ways that are really difficult to predict,” she said.

Considering the potential consequences in the United States and abroad, Sheiner believes the debt ceiling will be lifted or suspended — eventually.

“There’s no other way around it,” she said. “There’s no way that Congress is going to cut spending 20% in the middle of the year. It would plunge the economy into a recession. It would be a terrible policy.”

She added: “If you care about the long-term debt, you have to actually change different laws, Social Security law, Medicare, or the tax law … you want to do that in the appropriate process, you want to do it well thought out. It’s not the kind of thing that should be done under duress.”

CNN’s Maegan Vazquez, Matt Egan and Tami Luhby contributed to this report.

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