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Debt ceiling debate flirts with national economic disaster

Congress extended the federal debt ceiling in October, but a new deadline nears. AP Photo/J. Scott Applewhite

As a new deadline fast approaches on the decision to raise the nation’s debt limit, a certain doomsday urgency nears. When Democrats and Republicans were locked in a stalemate over this same question in October, many predicted dire economic consequences should Congress fail to act. 

Party leaders, however, were able to extend the reckoning until December. Now if Republicans remain resolute in voting against increasing the limit, which sets the maximum amount the U.S. federal government can legally borrow, the country will likely witness a replay of the political brinksmanship. And maybe worse.

But just how economically catastrophic would failure to act on the debt limit be? News@Northeastern talked about the consequences of breaching the debt limit with Northeastern economist William Dickens, distinguished professor of economics and social policy. 

man wearing blue button down

William Dickens, university distinguished professor of economics and social policy, poses for a portrait. Photo by Matthew Modoono/Northeastern University

“Huge, huge consequences would result from any default of U.S. debt,” he said earlier in the fall, before the October crisis was averted. As the showdown recommences, here’s Dickens’ take on the possible scenarios were Congress to go beyond the brink.

 

What happens if the debt limit isn’t lifted in time?

One could imagine a lot of different things that would start happening. For example, laying off non-essential federal employees to bring down the outflow of money to get it closer to the inflow of money. And, of course, that is going to have an immediate impact on the economy. Total federal expenditures are on the order of about one-third of the economy, but most of that is transfer payments and in particular, Social Security, so a much smaller fraction of that is government employees and government programs, paying contractors and things like that. Another thing: The Social Security fund is independent of the budget, but the people administering Social Security are government employees. If they’re laid off then there could be an interruption in the flow of benefits and there could be problems with new people getting their benefits.

 

What goes wrong from here? There is the issue of servicing all that debt.

If there’s a serious possibility of this becoming a permanent problem, another thing that could happen is the government would stop paying interest on the debt and stop redeeming the bonds that are outstanding. On an ongoing basis the government has issued 90-day bonds, 30-day bonds, and in 30 or 90 days it not only has to pay interest but it has to make whole the people who bought the bonds to begin with. 

If it doesn’t have money to pay interest or to redeem the bonds that are outstanding, then the U.S. government is in default on its debt obligations just like a corporation that goes bankrupt. And if that happens then the Social Security Administration has a different set of problems because it has to be able to sell the bonds that it holds in order to pay the Social Security checks. 

So, if the government were to default on the bonds and the bond market were to collapse as a result of that, then the Social Security Administration might not have the money to pay Social Security.

 

How do the dominoes fall from there?

And then there’s the huge, huge consequences that would result from any default of U.S. debt. U.S. Treasury bonds are held as a safe asset by all kinds of different financial institutions. Were banking regulators to suddenly decide that Treasury bonds and Treasury bills are not a safe asset, the capital requirements of banks all over the world would go up. So they would have to pay in more capital in order to function according to the rules that require a certain ratio of capital to assets. So they would either have to raise capital or dump some assets—and that could lead to the sort of crisis that we had in 2007-2008.

A lot of interest rates depend on the interest rates on bonds—and they’re considered a risk-free asset; other things get marked up over the top of them according to their riskiness. If suddenly you were to say U.S. bonds aren’t worth the paper that they’re written on, then everything else starts looking suspect as well. There would be general chaos in the financial system.

Now, none of these things has to necessarily happen—it’s a political decision as to what things happen and what things don’t. And it matters a great deal for how long the standoff goes on. If you are able to get by for a while laying off a bunch of workers, then maybe you don’t immediately have to default on the debt.

 

At a certain point would a recession ensue?

Yes, unquestionably, if it were to go on for months, the country would be in a recession—possibly even before that because of the anticipation of the problems that would be caused. It doesn’t require the second and third round of cuts … because people are going to anticipate the cuts and they’re going to cut back on their own business activities. Interest rates are going to go up, people are not going to want to buy new houses, and so on. I don’t think there’s any question that it wouldn’t trigger a recession at some point if it became clear it was going to be a long-term problem.

 

Are you in favor of abolishing the debt limit?

It’s one of those things that obviously should be the case. [Politicians are] going to vote for a budget with a deficit that puts us over the debt limit, but [they]’re not going to allow the government to go over the debt limit? It’s absurd. It’s political theater on an ongoing basis and it’s one of those things everyone knows shouldn’t be there. Nobody wants to take responsibility for getting rid of the debt ceiling, but I don’t think you’d find an economist who’d say the debt ceiling is a good idea.

For media inquiries, please contact Marirose Sartoretto at m.sartoretto@northeastern.edu.

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