Last-minute deal on debt ceiling could still spark recession even if US avoids default

A deal in the coming days to raise the nation’s debt limit won’t necessarily sound an all-clear signal for the U.S. economy.

Sure, it would avert the “economic and financial catastrophe” envisioned by Treasury Secretary Janet Yellen. That doomsday scenario features global financial markets in turmoil, mortgage rates rising, seniors missing Social Security checks and millions of jobs wiped out.

But an 11th-hour agreement that narrowly averts default but frays nerves, sinks stocks and pushes up interest rates could still do some damage, as did similar standoffs in 2011 and 2013, and even push a frail economy into recession. That’s far more likely than a breach of the debt limit that triggers financial calamity.

Fitch Ratings late Wednesday put the nation's AAA credit rating on "ratings watch negative." It noted that it still expects negotiators to reach a deal but said risks that the U.S. could begin to miss some payments have risen. It cited "increased political partisanship that is hindering reaching a resolution to raise or suspend the debt limit despite the fast-approaching x date

“The economy is already very fragile and on the precipice of recession,” says Mark Zandi, chief economist of Moody’s Analytics, who is among the minority of economists predicting the U.S. will avoid a downturn this year.

In the event of a nail-biting, down-to-the wire agreement that roils already volatile markets, a slump “is very possible,“ Zandi says.

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What is the debt ceiling?

The debt ceiling is the cap placed on the amount of money the government can borrow to pay for everything from Medicare benefits and military salaries to payments it owes bondholders for prior debt. A deal and vote to approve it doesn’t pledge additional spending. It just raises the total the government can borrow to pay for commitments already passed by Congress.

If the limit isn’t raised, the government would have to scramble to pay bills with only the revenue it brings in from taxes. That would force the Biden administration to decide whether to pay Social Security recipients and federal employees or bondholders who have lent money to the government.

A default would occur if the U.S. fails to pay back bondholders, but not funding other government outlays would still pummel the economy.

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Yellen has said the government could run out of money to pay its bills as early as June 1 if Congress doesn’t raise the nation’s borrowing authority, giving President Joe Biden and Republican lawmakers a little over two weeks to reach an agreement. Republicans are demanding sharp spending cuts but Biden says such budget haggling should be unrelated to the debt ceiling.

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What happened to the debt ceiling in 2011 and 2013?

In 2011, Republicans similarly demanded that President Barack Obama agree to cut the deficit in return for increasing the debt ceiling. An agreement was reached on July 31, just two days before the government’s borrowing authority was set to run out. Despite the deal, the brinkmanship fomented uncertainty about the nation's creditworthiness and prompted S&P Global Ratings to downgrade the U.S. credit rating for the first time in history.

The S&P 500 index of stocks tumbled about 17% during the episode and didn’t recover until the following year, according to a Treasury report, reducing household wealth by $2.4 trillion. Consumer and business confidence slid and didn’t fully rebound for months, well after the debt ceiling deal had been reached. Borrowing costs, such as for mortgages, rose. And consumer and business spending declined, the Treasury report said.

All told, the crisis caused a sputtering economy still recovering from the Great Recession of 2007-09 to shrink at an annual rate of 0.16% in the third quarter, Zandi estimates. Without it, he reckons, the economy would have expanded by 2.6%. The impasse pushed up the unemployment rate by 0.3 percentage points and reduced employment by 340,000 jobs, he reckons.

A similar standoff in the fall of 2013 also went down to the wire, with Congress hiking the debt ceiling a day before the Oct. 17 deadline. In early October, with no deal in sight, the federal government partially shut down and hundreds of thousands of federal workers were furloughed.  

Zandi estimates the crisis cut GDP growth in the fourth quarter of 2013 by half a percentage point, with about half of the toll caused by the partial shutdown and the rest by a cloud of uncertainty that sapped consumer and business confidence and spending.

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How much could today's debt ceiling drama hurt the economy?

Even if a deal is reached, the deadlock has created some uncertainty. Yields on short-term Treasury notes maturing after June 1 have soared. And the cost of credit default swaps – insurance in case the U.S. defaults – have hit record highs. Stock markets generally have taken the conflict in stride but have been more volatile in recent days as the deadline has drawn closer.

Assuming the debt limit isn’t breached, the White House estimates an eleventh-hour agreement still could increase borrowing costs and hurt investment. That could:

• Cut third-quarter GDP growth by 0.3 percentage points.
• Slice employment by 200,000 jobs.

Zandi concurs –  if a pact is reached by late next week. Under a possible scenario, the two sides could agree to raise the debt limit for a few months and then dicker to lift it again in September before the end of the fiscal year at the same time they negotiate the fiscal 2024 budget, Zandi says. That would allow Biden to say the debt limit and spending talks are separate. But deferring the conflict to late summer would mean lingering uncertainty that could dampen the economy.

If the drama extends to within a day or two of the June 1 deadline, stocks could fall significantly and the economic fallout could look similar to 2011, Zandi predicts, meaning:

• GDP would be slashed by more than 2 percentage points.
• Employment would fall by a few hundred thousand jobs.

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How does cutting spending hurt the economy?

Oxford Economics also figures an agreement before the deadline could ding the economy but for a different reason. If Biden agrees to $2.4 trillion in spending cuts – slightly more than half the amount demanded by Republicans – that would turn a mild recession into a severe one, says Oxford economist Nancy Vanden Houten.

What would happen then?

• GDP would decline by 2.3 percentage points in the second half of the year instead of the 1.5 points Oxford has forecast.
• An additional 460,000 jobs would be wiped out, says Oxford Chief U.S. Economist Ryan Sweet.

What happens if the debt ceiling is reached?

If Biden and GOP lawmakers fail to strike a deal by the deadline:

• Stocks likely would crater.
• Interest rates would spike for mortgages, corporate bonds and other loans, Moody’s estimates.

In a short-term debt limit breach that leads Congress to resolve it within a week, here's what would happen:

• GDP would fall by 0.7 percentage points from its peak to its bottom.
• 1.5 million jobs would be shed.
• Unemployment would rise from 3.4% to nearly 5%, Moody’s estimates.

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What if the debt ceiling standoff drags on for weeks or months?

In a prolonged breach of the debt limit, “the blow to the economy would be cataclysmic,” Moody's says.

• The federal government would have to slash outlays as funds run dry and credit rating agencies would downgrade Treasury’s debt.
• Banks would be reluctant to lend and households and businesses would sharply pull back spending and investment.
• GDP would plunge by 4.6 percentage points.
• Unemployment would jump to 8%.
• 7.8 million jobs would be lost, plunging the U.S. into a deep recession, Moody's estimates.

Even a decade from now, the research firm says, GDP would be nearly a percentage point lower and there would be 1.2 million fewer jobs than if the crisis hadn't happened.

Contributing: Anna Kaufman