Even flirting with American default takes an economic toll

As debt limit negotiations in Washington continue and the date by which the US government could be forced to stop paying some bills approaches, all involved have warned that such a default would have catastrophic consequences.

But maybe it doesn’t take bankruptcy to hurt the US economy.

Even if a deal is struck at the last minute, the long uncertainty could drive up borrowing costs and further destabilize already shaky financial markets. It could lead to a slump in investment and corporate hiring when the U.S. economy is already facing heightened risks of recession, and could hamper funding for public works projects.

More broadly, the stalemate could erode long-term confidence in the stability of the US financial system, with lasting consequences.

At this point, investors are showing little sign of alarm. Although markets fell on Friday after Republican leaders in Congress declared a “pause” in negotiations, the declines were modest, suggesting traders are betting that the parties will eventually reach an agreement – as they always did before.

But investor sentiment could quickly turn as the so-called X-date approaches, when the Treasury can no longer continue to pay government bills. Treasury Secretary Janet L. Yellen has said the date could come as early as June 1. One thing is already happening: As investors fear the federal government will default on Treasury bonds that are due to expire soon, they have began demanding higher interest rates as compensation for greater risk.

If investors lose confidence that Washington leaders will resolve the stalemate, they could panic, says Robert Almeida, a global investment strategist at MFS Investment Management.

“As the stimulus wears off, growth slows, you see all these little mini fires,” said Mr. Almeida. “It makes an already difficult situation even more stressful. When the herd moves, it tends to move very quickly and violently.”

That’s what happened during a debt ceiling stalemate in 2011. Analyzes after that almost standard showed that the plummeting stock market evaporated $2.4 trillion in household wealth, taking time to rebuild, and costing taxpayers billions in higher interest payments. Today, credit is more expensive, the banking sector is already turned upside down, and an economic expansion is starting to slow down rather than start.

“2011 was a very different situation — we were in recovery mode from the global financial crisis,” said Randall S. Kroszner, a University of Chicago economist and former Federal Reserve official. “In the current situation, where the banking system is very vulnerable, you take more risk. You pile vulnerability upon vulnerability.”

The mounting voltage can cause problems through a number of channels.

Rising interest rates on federal bonds will spill over into borrowing rates on car loans, mortgages and credit cards. That hurts consumers, who have taken on more debt – and are taking longer to pay it back – as inflation has pushed up the cost of living. Increasingly pressing headlines may prompt consumers to withdraw from purchases, which power about 70 percent of the economy.

While consumer confidence is deteriorating, this can be attributed to a number of factors, including the recent bankruptcy of three regional banks. And so far it doesn’t seem to be reflected in spending, says Nancy Vanden Houten, senior economist at Oxford Economics.

“I think all this could change,” Ms Vanden Houten said, “if we get too close to the X-date and there is real fear of missed payments on things like Social Security or interest on the debt.”

Suddenly, higher interest rates would pose an even bigger problem for highly indebted companies. If they had to roll over loans due soon, it could blow their earnings forecasts at 7 percent instead of 4 percent, leading to a rush to sell stocks. A widespread drop in stock prices would further erode consumer confidence.

Even if markets remain calm, higher borrowing costs deplete public resources. An analysis by the Government Accountability Office estimated that the 2011 debt limit stalemate increased Treasury borrowing costs by $1.3 billion in fiscal year 2011 alone. At the time, the federal debt was about 95 percent of the country’s gross domestic product. Now it is 120 percentwhich means paying off the debt can get a lot more expensive.

“It will ultimately crowd out resources that could be spent on other high-priority government investments,” said Rachel Snyderman, a senior associate director of the Bipartisan Policy Center, a Washington think tank. “That’s where we see the cost of brinkmanship.”

Interrupting the smooth functioning of federal institutions has already caused headaches for state and local governments. Many issue bonds using a US Treasury mechanism known as the “Slugs Window”, which closed on May 2 and will not reopen until the debt limit is raised. Public entities that often raise money in this way now have to wait, which could delay major infrastructure projects if the process drags on.

There are also more subtle effects that could survive the current confrontation. The United States has the lowest cost of borrowing in the world because governments and other institutions prefer to hold their assets in dollars and government bonds, the only financial instrument believed to carry no risk of default. Over time, those reserves have begun to shift to other currencies, which could eventually make another country the haven of choice for big cash.

“If you’re a central banker, and you’re looking at this, and this is kind of a recurring drama, you could say, ‘we like our dollars, but maybe it’s time to hold more euros,'” he said. Marcus Noland, executive vice president of the Peterson Institute for International Economics. “The way I would describe that ‘Perils of Pauline’ short-of-default scenario is that it just gives that process an extra push.”

When do these consequences really start to take effect? In a sense, only when investors move from accepting a last-minute deal to anticipating a default, a time that is vague and impossible to predict. But a rating agency could make that decision for everyone else, too, as Standard & Poor’s did in 2011 — even after a deal was reached and the debt limit was raised — when it downgraded US debt from AAA to AA+, driving stocks down in value . dive.

That decision was based on the political rancor surrounding the negotiations and the sheer size of the federal debt — both of which have soared in the intervening decade.

It’s not clear exactly what would happen if the X date went by without a deal. Most experts say the Treasury Department would continue to make interest payments on the debt and instead defer other obligations, such as payments to government contractors, veterans or doctors who treat Medicaid patients.

That would prevent the government from defaulting on debt immediately, but it could also erode confidence, shake financial markets and lead to a sharp drop in hiring, investment and spending.

“Those are all defaults, just defaults for different groups,” said William G. Gale, an economist at the Brookings Institution. “If they can do that to veterans or Medicaid doctors, they can eventually do it to bondholders.”

Republicans have proposed linking an increase in the debt limit to sharp cuts in government spending. They have pledged to spare Social Security recipients, Pentagon spending, and veterans’ benefits. But that equation would require significant reductions in other programs — such as housing, toxic waste cleanup, air traffic control, cancer research, and other categories that are economically important.

The Budgetary Control Act of 2011, which resulted from that year’s stalemate, led to a decade of limits that progressives have criticized to prevent the federal government from reacting to new needs and crises.

The economic turbulence caused by the debt ceiling deadlock comes as Federal Reserve policymakers try to curb inflation without triggering a recession, a delicate task with little room for error.

“The Fed is trying to thread a very fine needle,” said Mr. Kroszner, the former Fed economist. “At some point you break the camel’s back. Would this be enough to do that? Probably not, but do you really want to take that risk?”